If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Monday, 13 April 2009

Greg Pytel: The Largest Heist in History

October - December 2008

Building the Great Pyramid: The Global Financial Crisis Explained

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

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

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

Money Making Machine

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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


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

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

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

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

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

Weighted average LOAN/DEPOSIT RATIO = 174.26%

Additional information:

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

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

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

UK 137%
Germany 121%
USA 105%
France + Benelux 103%
UK + Asia 89%

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

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

Below is a draft of explanation (in a rigorous way) why financial institutions, technically, complied with Basel 1 and/or Basel 2 of capital requirements (8%), yet they collapsed.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


  1. In essence you are right, but there's more to it. There are at least six factors that, in combination, explain where we are today:

    1) Financial engineering created mechanisms to multiply money through pyramid lending, with all risk 'securitised'.

    2) Trade imbalance between the US and China led to seemingly indefinite rises in Western asset prices, so providing a sustained atmosphere of confidence.

    3) Reckless monetary policy kept interest rates too low throughout the decade so sustaining the trade imbalance and promoting further financial engineering as the only way to turn a profit.

    4) There was inadequate financial regulation - Basel 1 and 2 may cover this in theory, but no-one was covering it in practice. So the regulators were blind.

    5) A sharp correction pushed up defaults and so triggered the loss of confidence. This was probably the spike in oil and commodity prices.

    6) The interconnectedness of the entire global financial system meant that when the wheels come off it was simply not possible to 'let it fail'.

    A sorry tale.

  2. Alex, thanks. Please pass my blog address.

    Spot on: I completely agree. But it is only as much as one can put on the blog. I will be addressing some of your points in the next few posts, but with regards to: "there's more to it", I encourage you to consider my assessment in my article:

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

    Well, when one dies of AIDS, "there's more to it": pneumonia, infection, flu, etc. The point I am making is that loan to deposit ratio above 100% turn the financial system into a pyramid scheme. By its very nature (an exponential growth of spread between banks’ balance sheets and cash available) it is bound to collapse. The factors you listed are valid and important, but as my analysis showed they were contributory. In my view, in the presence of loan to deposit ratio above 100% they could have accelerated or delayed the collapse of the pyramid. But there was no way of preventing it. If not for the factors you listed, something else would have been an immediate trigger or exacerbating factor of the collapse process. It is like someone started riding the bike with constant acceleration (theoretically reaching infinite speed). When the rider falls of the bike you might look for immediate causes: oil spill, punctured tyre, debris on the track, etc. But the fact is that with a speed going possibly to infinity, the rider was also bound to fail anyway. It was only a matter of time. Such is the effect of loan to deposit ratio above 100% in the banking system.

    Many thanks: your comment will keep me going with my work and help me greatly addressing details of the current mess.

  3. Automaticaly Induced Debt Sindrome is the inevitable outcome of filling AAA's holes with seminal Strategicaly Hyped Investment Tranches

    The Banking system perfectly mirrors the sexual practices condoned by populist pollytitians trying to make complete tutts out of themselves at unborn taxipayers expence

  4. Greg

    Its nice to talk to others who grasp the scale of the challenge - the media don't seem to be there yet. Though the Economist is getting there.

    I don't think its as clear cut as you imply that debt leverage is the root cause.

    I think trade imbalance could have caused a crisis on its own (indeed, I'd probably put this as #1 on my list). After all, it permitted excessive government debt.

    Interest rate policy since the dotcom bubble 9/11 could have caused eventual runs on banks regardless of absolute leverage, once it became clear that banks were forced to lend recklessley in order to be 'profitable'.

    The background to the failure of regulation lies in the politics of the 1980s - a long time before the leveraging really began. Lousy regulation could be seen as the root 'cause'.

    Any price shock could have been the trigger. The significance of the fact that it was oil is that it will likely recur as soon as any 'recovery' comes. Peak Oil could be seen as the cause (credit was the irresistible force, oil reserves are the immovable object...)

    And finally, interconnectedness - which made the whole thing faster, and the end messier - was driven by technology. Though this is probably the least profound 'cause' in itself.

    Different causes, leading to different effects, combined to get us to where we are. I think a robust analysis has to consider them all.

    Keep up the work - I look forward to reading it.

  5. This comment has been removed by the author.

  6. An analogy to explain my last comment.

    The economy is a car.

    100%+ lending ratio is like the brakes failing, causing a crash.


    Trade imbalance with China is like the accelerator being jammed on, causing a crash.

    Commodity prices are like a brick wall across the road, causing a crash unless you're going very, very slowly.

    Regulation and central bank policy are like dodgy mechanics whose carelessness causes the accelerator to jam and the brakes to fail.

  7. Thanks Alex for an awesome comment that lets me explain that loan to deposit ratio above 100% was a sufficient cause for the current liquidity crisis.

    Loan to deposit ratio above 100%, in my analysis, with respect to your car analogy is NOT like the brakes failing causing the crash. It is like the accelerator being jammed. Furthermore it is a very vicious accelerator. A constant car acceleration increases your speed in a way that you cover a distance in time increasing at a polynomial rate [in fact: quadratic: s = a*square(t)]. A loan to deposit ratio above 100% gives acceleration in terms of the growth of balance sheets at an exponential rate. That is why it is a pyramid!

    So, from your excellent analogy, it follows: if you drive a car whose speed is continuously increasing at an exponential rate (without an upper limit), you will eventually crash regardless of other causes. If you do not crash at 10 km/h, you will do it at 100km/h, or 1000km/h, or 10000km/h, or 100000km/h and so on. Because of exponential growth of the speed, you will reach any arbitrary high speed that very fast. (Think in terms of logarithmic scale: the distance you cover at a unit of time increases at exponential rate)

    However after the crash (at whatever speed), you may start looking for immediate causes of the crash, a direct failure that caused it. It may well be that you could not see a turn early enough, or a lorry crossing the road saw you but you were driving too fast, or you did not manage to control the car as you had to scratch your itchy head :-), or whatever...

    The fact is, and I am sure you will accept it, that if you drove a car with speed increasing to infinity at some point you would crash. I cannot tell at what speed, at which location and after what period of time that would happen as that will depend on other contributory factors. By this analogy, if the financial system sustains loan to deposit ratio above 100%, at some point to will collapse due to liquidity shortage. This is why I consider it as the sufficient condition of the current crisis.

    I hope my explanation covers your previous comment: the factors you mentioned resulted from loan to deposit ratio above 100% and, if not, where contributory causes. This is the outcome of my analysis.

    I have not done a detailed quantitative analysis yet but it is my hypothesis that:

    - trade imbalance with China to such a huge extent was effectively a result of loan to deposit ratio above 100%;

    - commodity prices at such a high level were effectively a result of loan to deposit ratio above 100%.

    - [and so on in relation to other specific factors]

    But it is a bit complicated as we have to look into a combined effect. For example, the one or the two or more of the above factors might have been possible without loan to deposit ratio above 100%. But then, if loan to deposit ratio was below 100%, a lot of others phenomena that ballooned the market would not have been possible. So in effect there still could have been a crash at some parts of the market, but it would have been cushioned by different healthy parts. Loan to deposit ratio above 100% is a cause of the totality of the financial collapse. It is also the root cause behind the scale of such a massive scale of factors that you mentioned. Above all, it transformed the financial system into pyramid and this was illegal.

    Logically, I am not denying that there could still be a different sufficient cause of such a liquidity crisis, but I doubt that it is in this particular instance.

    [As a side note, think in number terms: the world’s GDP in 2007 was $53 trillion; the notional value of outstanding derivatives in December 2007 was at least $1.144 quadrillion, at least 21 times higher!]

  8. As far as I am concerned regulations were OK:

    1. Basel I and Basel II made provision for minimum healthy Tier 1 capital requirements.

    2. Pyramid schemes have been illegal for some time. (E.g. loan to deposit ratio above 100% is illegal as it is an absolutely classic, textbook, example of a pyramid scheme.)

    If both were observed then the current liquidity crisis would not have happened. The problem was that existing law and regulations were not observed. And all responsible (financiers, regulators, politicians) must be held into account on civil liability and criminal accountability.

    There could have been a different crisis for a different reason and we could only speculate whether, if that happened, it would have been better or worse. It is a completely different subject however.

  9. I read a bit of your blog on "The Largest Heist in History," but found it difficult to understand your view.

    I agree that this is a spectacular robbery, but after reading your view, I looked for your profile to learn more about your background -- your education and experience. I was disappointed to find nothing.

    I always teach my students that when they write, they should establish their credibility first -- by showing why we should listen to them as proven experts without bias. If they fail to do that, the reader will doubt what they say. After all, a writer may have little knowledge of the subject ("a little learning is a dangerous thing" as Alexander Pope wrote), or the writer may have a goal that is inconsistent with telling the truth.

    My guess is that you are doing your best to tell the truth and explain things accurately, but may not have complete knowledge. So, since I am writing quite a bit on this and related topics recently, I thought this would be a good time to explain the situation for the general public -- much as you are trying to do.

    For details of my background, you can look at my website: http://fredricwilliams.freeservers.com. Briefly, when I was 14 (in 1959-60) I spent a year studying the stock market crash of 1929 and the resulting Great Depression in the US, writing a 30-page paper on the subject. I began investing in stocks in 1963, and first wrote on finance and investment in 1977, when I was paid about $5,000 in current dollars for an article on gold as an investment. I had been trained by NASA to be a senior government executive in the early 1970s, and made enough money on real estate in the inflation of the 1970s to retire at 35. I then published a personal financial newsletter, Washington Cashletter, beginning in 1980, advising people to invest in the stock market (it advanced about 200% over the next decade), and subsequently did some consulting and teaching.

    I hope this explanation will help further your own understanding, although its main purpose is to help people who may have much less knowledge of the subject than you do.

    You seem to think that the reserve banking system is perfectly fine, although history has shown that this system has a fatal flaw. When depositors demand their deposits back, and the money has been loaned for thirty years on a mortgage or three years on a car loan, it isn't available. It can be made available only if the bank can turn its long-term loans into cash. Thus, a banking run can occur at any time, and the bank really doesn't have the money that was deposited. This was the subject of a famous old movie It's a Wonderful Life. It can be prevented in the US only if someone quickly loans the bank cash on its assets -- or buys the assets quickly.

    The problem of toxic assets is not that banks loaned too much money. In fact, the system for making loans made perfect sense. People were loaned money from depositors, but then the loans were packaged and sold to investors. The result was to return the cash to the bank that made the mortgage. Depositors were not at risk (beyond the usual risk due to fractional reserve banking).

    The problem occurred at the other end. Banks thought these securitized mortgage packages were safer than the actual mortgages that they might have just held on to. Mortgages are usually excellent investments, paid without fail in about 99% of the cases and the underlying collateral -- housing -- regularly increases in price (mainly due to the steady inflation of currencies). Furthermore, risks were reduced by packaging mortgages from a variety of locations (protecting against a decline in any one city or region), organized by level of risk (riskier mortgages were packaged separately from less risky mortgages), and insured by a large international insurance company. What could be safer?

    However, after 9/11, the US Federal Reserve lowered interest rates substantially to prevent the economy from freezing up or spiraling into a recession. The low interest rates caused housing prices to rise at an unusually high rate for several years. Then, perhaps in part because housing prices were rising so rapidly, suggesting inflation that was not being observed in the US Consumer Price Index, which does not include housing to any appreciable degree in its calculations, the Fed reversed course. This began a collapse in housing prices as the higher mortgage rates sharply reduced demand.

    So these securities, presumably safe packages of insured loans, suddenly were hit from all sides. First, interest rates were rising, which made the old mortgages (and the related securities) decline in value since investors preferred the higher rates now available. Second, because housing prices were now declining, the value of the underlying collateral was declining as well, making the securities less secure. Third, because some buyers had bought property with adjustable rate mortgages, the rising rates and lower housing prices caught them in a trap; they could not refinance, and there was a steady increase in foreclosures. Fourth, a recession in the US was beginning, threatening loss of jobs and more foreclosures.

    Now, what seemed an advantage -- securitization and insurance -- was reversed. Prior to securitization, the value of the mortgages on a bank's books was fairly clear. If it was being paid, it was valued at face value. If not, it was in foreclosure and had a reduced value based on the costs of foreclosure and resale. Typically this might mean the bank's mortgages were valued at 99.5% of their original value. In a crisis, with many foreclosures, this might drop to 97%, but that would be unlikely. In the case of a run on the bank, it could get cash for its fully valued mortgages.

    However, with securitization, there was a market for the securities. Because there were a great many securities each with thousands of different loans, after the first sale was made to an investor, usually to an institution, not many actual resales occurred. Now, however, because it was unclear which securities included mortgages in the greatest danger and which did not, the very small number of sales saw prices that were extremely low -- less than 50% of the face value of the securities. [I saw something similar in the 1980s with investors who had bought real estate securities and found no market for them.]

    Now, the banks had a new problem. They had bought these securities themselves (not the smartest move, but it seemed safe), and the securities had to be valued, not on the grab-bag of underlying assets, but on the recent sales of such securities at fire-sale prices, an accounting rule called "marked to market".

    Although foreclosures represented only a few percent of the mortgages, the practice of marking to market and the limited number of buyers for the securities dropped the value of these bank assets by 30-70%. The banks were suddenly insolvent -- as were all those who had insured them and other financial institutions against losses -- including all the investment banks.

    So, in this situation, what should be done? If the banks failed, the depositors were secured by the FDIC, in theory. However the FDIC, despite its name (Federal Deposit Insurance Corporation) was a private corporation funded by a small insurance fee paid by banks. It's assets would be exhausted by the first few banks that failed. It could not pay more than a tiny fraction of depositors if there were a run on the banks. [The FDIC recently got a $500 billion bailout from the government -- just to cover more bank failures.]

    Thus, to avoid a collapse of the banking system, the US Treasury and Federal Reserve began sticking fingers in the dike. It could not eliminate mark-to-market, because this would not give anyone confidence in the bank assets. So they cut deals to give money to the insurance companies and banks, and investment banks acquired commercial banks to share in the bailout.

    The hasty effort to stop the panic may have prevented a collapse, but it did not slow the overall decline. People now became more afraid, worsening the housing price decline and the recession. Furthermore, since little or nothing has been done to preserve the value of the underlying mortgages (something that could have been done with a government guarantee of the principle and interest), the value of the assets continues to decline, requiring further bailouts (currently a plan to buy the low-priced assets from the banks).

    That's about it for the general outline.

    Fredric Dennis Williams

    On Fri, Apr 24, 2009 at 2:00 PM, Greg Pytel wrote:

    Dear Fredric

    I specially do not advertise my credentials as arguments should be strong enough without them (here I am dealing with maths). But my name is a real one although I am not the only one in the world with this name. I am a mathematician who some years ago specialised in computational complexity. I have also worked in business (in fraud investigations).

    I can also assure you that I have no conflict of interest or vested interest or indeed any interest with respect of the subject I write about (apart from searching for the best way of explaining the current crisis). In fact I am so terrified by my findings that I would be most grateful if someone proved that my pyramid model of this crisis is flawed.

    I do not assume that anything is correct in the financial markets. I only came to conclusion that a loan to deposit ratio above 100% was a single sufficient cause for the current financial crisis. Basically even if anything else was ideal (and I am pretty sure it was not) the effects of loan to deposit ratio above 100% were powerfull enough to cause the liquidity crisis like the current. Therefore in that sense it was easily predictable and with loan to deposit ratio above 100% inevitable regardless of other factor. (For more please refer to Comments below the main article on my blog.)

    My model can be explained in a few points related to real financial life:

    1. It is the fact (see the Tables at the end of my main article) that most markets sustained loan to deposit ratio about 100% for quite a long time. To see the effect of this please refer to the following bit of my article:

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

    2. Basically what happens is that with loan to deposit above 100% the spread between banks balance sheets and the cash on the market grows at exponential (i.e. extremely high and compounding) rate to infinity. It is in fact very similar to Zimbabwean scale inflation phenomenon whereby the spread between cash on the market and goods available grows in a similar fashion.

    3. At some point of that spread the lack of liquidity is inevitable. At that point pyramid collapses. The collapse is accelerated by a loss of confidence. It is a vicious cycle shortage of cash creates more demand for cash which creates even larger shortage of cash and so on. This is how a pyramid collapse looks like.

    4. I must admit that I did not look into individual factors that you mentioned. My hypothesis is that these factors were made possible or worse due to loan to deposit ratio above 100% or they were just contributory. In fact your explanation fits very well into my mathematical model. The mathematics of loan to deposit ratio above 100% is ruthless: it is a pyramid with books balance sheets heading at exponential rate to infinity and it must collapse. The trick was that for a long time a good part of the pyramid, i.e. strictly non-cash, was actually counted for Tier 1 capital reserve.

    5. If the basis of my explanation is wrong than it is perfectly possible that the banks’ balance sheets to cash on the market ratio can be infinite and that would be fine. I do not think this is OK.

    I do not want to sound too patronising (and I apologise if I do), but it is all explained on my blog. I know that for someone who does not look at life in terms of computational complexity (i.e. differences between logarithmic, polynomial, exponential, factorial, etc growth) what I write may be a bit impenetrable. I tried to simplify it, but still it is not that easy. (It is no accident that I choose Professor Bartlett’s observation as the motto for my blog.)

    Thanks for your message. And I am looking for more feedback. (Maybe you put comments on my blog?)

    With best wishes


    Dear Greg:

    Thanks for the sincere reply. Like you, I have no illusions that I have all the answers -- or even a perfect understanding of the problem. And, while I was the top math student in my small high school and #41, I think, in the state of Wisconsin, after two years of college math I decided this was not the best field for me. As for banking, I am far from an expert. I am sometimes accused of being patronizing, too, but I think as long as our goal is to inform (and we aren't unreasonably insecure) exchanging views shouldn't be a problem.

    I think that your responsiveness and uncertainty both contribute to the hope that we might eventually be able to fully and correctly understand the problem in all its facets. I will add my comments to your blog, as you suggest. Keep up the good work, and keep studying. My own goal is to not only define the problem and its cause, but identify a proper solution. I first worked on this problem in 1981, when I met the architect of the New Deal and he asked me to give up making money and try to be more helpful (I did the first, whether I can achieve the second is yet to be seen).

    I came across a couple of items discussing loan-to-deposit ratios, the first from the Fed, saying that banks with higher ratios (still well below 1:1) were less likely to make a loan than those with lower ratios -- and concluding that this was an indication that the data was relevant, even if many banks were now re-selling their loans (which would allow them to make more loans and therefore more fees, without increasing their deposit base). See http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=2530

    The other item is from the FDIC, giving the loan-to-deposit ratio for US banks by state in 2007. I see no clear pattern in the data. See http://www.fdic.gov/news/news/press/2008/pr08051a.html

    My guess is that psychological effects are critical to banking stability, although you are surely correct that if a bank loans money at a higher rate than it obtains deposits, it is headed for trouble. However, it seems to me that this is possible only if the bank borrows from other sources (banks, etc.). If it borrows short and loans long, as it does with most deposits, this is a prescription for disaster if its lenders ask for their money. If, on the other hand, it re-sells the loans for cash, I see no particular danger, since it no longer has the loans on its books (except perhaps for servicing).

    In any case, I will be reading further on your blog in the hope that I might improve my education.

    Fredric Dennis Williams

  10. A reader wrote the following comment directly to the blog author:

    I read you blog post "The Largest Heist in History", and I'd like to comment it, but since I'm not expert in the world of finance, I don't want to post directly on your blog page. First I'd like to state that I'm not a fan of conspiracy theories, but I agree with you that it doesn't make much sense to search for details of the current crash of the financial system, if there is a fault in it that renders it to self destruction, if it could not work even in theory, less in practice.

    The first thing I'd like to discuss about, is that I observed some confusion in your reasoning between loan-to-deposit ratio and the reserve ratio used in fractional-reserve banking. You state in one of your example that " In other words the banks were lending out on average £137.00 for every £100 paid in as a deposit." But that would mean that the bank was issuing £37 new money out of nothing, which is not possible for a commercial bank, only central banks can do that (or any other bank with the right to print money) according to my knowledge.
    In this case the bank has to borrow from somewhere £37 plus an amount to increase its reserve. Actually in fractional-reserve banking if a bank gets from somewhere £100, it cannot lend more than £100 from this £100 acquirement and the loan-reserve ratio cannot exceed 100%.

    An interesting problem is the haze about the source of financing the banks use for obtaining funds that they can use for lending or create reserves. I think a real problem here is that not all the money put in reserves is supported by real values in the economy (the reserve is not entirely from conventional deposits or money backed by value, and even some of the deposits originate in the carry trade). In this way the fractional-reserve banking is multiplying money that has no value.

    That's because in the money creation and destruction cycle money is created when a bank makes a loan to a customer and money is destroyed when the customer repays the loan. Only the interest paid for the loan should remain permanently (until the underlying values lifetime) in the system and it represents the value created by the economic activity of the customer. In the case of fractional-reserve banking, if we assume that everybody can repay the loan it borrowed from the bank, one can think that this would work without problem, without creating
    excess money. But it is worth observing that when a bank makes a loan to somebody, that money may not be backed by value in the economy. For example consider that in a month there are built 10000 houses, but the banks are disposed to loan out money to 20000 customers for purchasing homes. The extra 10000 customers would not like to wait for another month (the next month anyway the banks would lend again to other customers) and they would push up house prices causing inflation. You can argue that this would increase supply (more construction), which is usually true, but there would be more profitable and easier to charge higher prices for increased demand than to raise supply to the level of demand. This way demand would be always ahead of supply until the lending is stopped. After that becomes evident that the price paid for the houses was too high.

    When money creation exceeds the growth of value producing economic activity, then we already have a pyramid scheme, since the money will be not supported by value. In this case one can read contented one's account statement, but when tries to purchase something with the money, it will immediately push prices higher, so the more one spends the more the remaining amount will be inflated. So, what is important are not the particular values of the different rates imposed on the banks, but the value of money pumped into the economy, and that has
    one reliable indicator, inflation.

    I think the real cause of the current crises was that central banks didn't look at house price inflation, though house prices grew with exorbitant rate, and pumped even more money in the system. This was because almost everybody opened long-positions against the housing market, and economic growth in general. Even the governments were interested in the (now evidently limited-term) economic growth induced by this huge money supply, since democratic governments nowadays acquire legitimacy for power by trying to sustain a high economic growth rate. You should see that Albanian-style pyramid schemes are not rare these days because people are not willing to participate in such a schemes, but because that they are prohibited by law. These pyramid schemes crashed rather quickly, and the rage following them caused trouble for the governments. But the pyramid scheme employed in the financial system is growing slower and lasts longer (since the crash can be delayed by creating new money), and in the meantime many forget that it has to crash anyway.

    It is also worth mentioning that once a pyramid scheme has been started, it is impossible to stop it in any other way than by a crash. For example if the Fed wanted to stop this pyramid before, it would caused an economic recession and unemployment similar to what we are experiencing now (though the total damage is lesser the sooner the crash happens). Most of the ordinary people, bankers and government would have blamed the Fed for the trouble and few would have understood the real problem.

    So, in my view the central banks and governments are responsible for the current trouble by not controlling the money supply, the other middle agents participated in the game because they knew they have a higher chance to win than to loose. The central banks should control the money supply by constantly changing the reserve ratio's of the banks according to inflation levels, not by fiddling with interest rates. In a healthy system (not damaged by wars, natural disasters) increased deposit withdrawals (possible bank run) would occur when interest rates are low, inflationary pressures are high and there is considerable economic growth. In that case if central banks increase the mandatory reserve ratios, banks would be forced to draw off money from the economy and this would cause interest rates going higher, money supply going down, and less depositor interested to withdraw money from the bank and invest in an economy slowed down. This would cause deflation (correcting previous inflation and going somewhat further) and then money would be introduced again in economy by decreasing again the reserve ratio. The reserve ratio should reflect the probability of deposit withdrawals. Driving the economy is like driving the car on a winding road: there are times when you should press the accelerator pedal, other times the break. The constant, stable economic growth that governments like to flaunt is a folly. There will be always swings but certainly these can be moderated, and this would be the role of financial regulation which was blundered.

    Monetary policy should be separated from economic policy. The first is about protecting existing values, the other about creating new ones. The first is concerned with reality, the other with wishes. Each has an adverse effect on the other in the short term, but this is normal. What was said to be an economic stimulus was in fact a pyramid scheme pandering to many people's wishes, but now reality kicks in. Surely no one should throw off the chains and shackles of reality.

    Now everything is messed up. When the government tries to bail out who where not the cause of the crash then it will bail out those who were, too. And if it lets to fail some institutions, it will hurt those whom not intended. The government should break up everything that is too big to fail, and those who are not supposed to fail should be put under tight fiscal regulation. Many would have not participated in a pyramid scheme if they knew what it was really (think of life savings and pension funds which were invested in the housing market).

    It is also worth considering what happens when in the fractional-reserve banking systems loans are defaulted and could not be recovered (there was no economic value created with the loan) leading to a collapse of a bank If the deposits lent out were central bank money, then the destruction phase of the lent money would not be fully performed, and money remains in the system which leads to inflation. If ordinary deposits are lost, then the depositors pay for their risk-taking. But if the depositors are bailed out, then again money appears without value support.

    There is a belief among leading economists, that a reduced level of inflation is healthier than no inflation at all, since this would force people to spend their money rapidly today, and to work hardly to have something to spend tomorrow. The real beneficiaries of such systems are those who earn their money through fees after an increased money circulation (mostly bankers, fund managers). Since the more money is added in the system, the more they will earn (a fixed percentage is always theirs), practically they do not have to fear much from

    Unfortunately we are all part of this pyramid scheme, and the end is always the same: a few winners and many losers.

    In response I wrote directly:

    Thanks for such a detailed feedback. What you wrote actually supports my model of the current crisis. I am agnostic to existence of conspiracy theories. I look at things on their merits. The current crisis is as much of conspiracy as Albanian business in 1996 - 1997. People just love making money... this is the biggest conspiracy of all :-) But maybe I am wrong on it

    It is a fact that banks were issuing loans with loan to deposit ratio above 100%. I refer to your example:

    "The first thing I'd like to discuss about, is that I observed some confusion in your reasoning between loan-to-deposit ratio and the reserve ratio used in fractional-reserve banking. You state in one of your example that " In other words the banks were lending out on average £137.00 for every £100 paid in as a deposit." But that would mean that the bank was issuing £37 new money out of nothing, which is not possible for a commercial bank, only central banks can do that (or any other bank with the right to print money) according to my knowledge.
    In this case the bank has to borrow from somewhere £37 plus an amount to increase its reserve. Actually in fractional-reserve banking if a bank gets from somewhere £100, it cannot lend more than £100 from this £100 acquirement and the loan-reserve ratio cannot exceed 100%."

    The bank could have borrowed this £37.00 from another bank issuing a AAA-rate paper, which the other bank booked in its Tier 1 capital. This way the cash was pumped out of the reserves (ending up in: offshore accounts, China or another Far East or Middle Eastern country with trade surplus, you choose) replaced by, ultimately, worthless papers that was considered as good as cash. However when the pyramid collapsed, this paper was worthless. That is why banks have problems with capitalisation now. Generally if the banks were settling their business in security papers rather than cash (and the value of this papers was growing at the time), ultimately a lot of banks ended up owning these papers and have no cash now. The cash did not disappear but it changed its owner: look into offshore accounts and countries that run huge trade surpluses.

    You also wrote: "I think the real cause of the current crises was that central banks didn't look at house price inflation, though house prices grew with exorbitant rate, and pumped even more money in the system." I agree with that: but the house price inflation was driven by banks giving loans at loan to deposit ratio above 100%. Simply lending unsustainable huge amounts of money. So what you wrote about is a cause whose underlying cause was lending with loan to deposit ratio above 100%. You should also note that a huge part of housing market transactions was cashless. Banks were trading securities, which at the time were valued very high. Once cash disappeared and the pyramid collapsed these erstwhile valuable papers are almost worthless. This what you observe now.

    I am also not an economist. I am a mathematician. It is an extremely trivial fact that if you start lending money with loan to deposit ratio above 100% you create a pyramid, which is growing very fast fast (i.e. the ratio between banks balance sheets and cash on the market grows very fast and technically it can go to infinity). Such a pyramid is bound to collapse.

    In my view it is very likely there were clever people that knew this and they engineered it for their huge personal gains. But it is also possible that the financial world is run by bunch of idiots none of whom heard about Cobham Thesis. In this case the current disaster is an accident caused by cretins. I think this option is less likely than a conspiracy theory, but on that point I do not really care. I am trying to deal with a technical side of the disaster.

    You should distinguished however the technical analysis from emotive element of the psychological causes (engineered or accident).

    Best regards


  11. The same reader as in the previous post responded privately:

    Thanks for your answer. I still don't understand clearly what are you trying to explain. The loan-to-deposit ratio usually means the ratio between the total loans and total deposits, not the money multiplying rate. You quoted some loan-to-deposit ratio levels from some articles, but I'm not sure they were used in the meaning you considered. In my interpretation when a bank has a loan-to-deposit ratio is 130% for example, we can exemplify this by stating that a bank has made loans in the value of $1.3bn and has deposits in the value of $1bn. If we assume that the total reserve requirements are 10%, then the bank has $130 million in cash or other risk-weighted assets (Tier 1 or Tier 2). In this case $430 million has come from borrowed funds. Not all borrowed funds are securities used only for pushing out more cash from the reserves by replacing it, since in the reserve usually there is not much cash compared to the volume of lending.

    A bank usually lends money and not securities, since if a mortgagee gets a loan then has access to money, the mortgagee pays with money for the seller and the seller has the right to withdraw cash from his account where he received the price of the sold property. So the loan-to-deposit ratio is not about the money multiplier but about the source of financing and the source of reserves.

    The problem with high loan-to-deposit ratio is that a high percentage of a bank's funds come from borrowing from banks in other countries and interbank lending. The central bank can do little to control the availability and withdrawal rate of these funds, in contrast it has a considerable influence on the behavior of domestic deposit-holders. Even if a central bank keeps tight regulation in a country, that regulation does not apply for foreign countries from where funds where borrowed. If in those countries the banks run in trouble, they will rapidly do all they can to withdraw their funds. So the problem with non-deposit funding is that is almost impossible to assess the probability of their withdrawals, and the availability of them and because of this is impossible to determine correct risk-weighted reserve levels. These funds are either carry trade or a transformation of short-term loans to long-term loans (a really risky business).

    An other issue which was not much discussed is that besides the fractional-reserve banking's money multiplication there is another source of money, the base money issued by central banks. Lending volumes usually come in waves: when central banks and foreign lenders pump money in an economy, the fractional-reserve banking rapidly multiplies it, but since it has to retain a percentage for reserves, the recollected money available for lending diminishes. Then the bank either gets new deposits or funding, or waits for the interests and principals from the previous loans to collect funds for new loans. With a rapid circulation of money and high volume of lending one can see that the money multiplication cycle ends rather soon, and new funds will be needed to sustain previous lending levels. But when the foreign sources of money observe that they fuelled a bubble, they will became more cautious and then the banks will run after capital, deflation begins, economy suffers, domestic deposits cannot increase much in recession, and even those economies suffer from where the previous funding had come.

    A solution for this would be that larger or all part of the reserves should be in cash, or non-evaporating assets. In the current situation if a large part of the reserves were constituted from mortgage backed securities or its derivatives, then is obvious that the loans and reserves failed simultaneously. The reserves have to be of the same nature that liabilities (cash deposits) are, because no one knows what will be their market value when they are needed.

    If there were no inflation or bubble, then the securities wouldn't be worthless. This is why I rather stress the importance of inflation. The real pyramid was in the real estate combined with the financial instruments invented by the bankers, though it could have occurred in other market segments. And I venture to state that this pyramid was started due to the reason any other pyramid was started: everybody hoped they will be among the (small number of) winners.

    Let me exemplify this: when the real estate properties began growing with high rates due to unrestricted lending (no central bank intervention), evidently many investors seized the opportunity. If an investor had an amount worth of 10 houses for example, then he began buying property or mortgage-backed securities and later sold them with profit, when seeing that the bubble continues, kept buying and selling again, his investment growing in value. Meanwhile the banks sold their loans, mixed and packaged them in different kinds of derivatives, securities, the cash was loaned out again and their reserves were also filled with these securities. As the house prices grew the number of house loans packaged in a security worth of $1 million evidently decreased. Then the bubble burst and the investor wanted to invest in gold or other commodity with his money stored in the bank. Unfortunately many other deposit holders thought the same way and a bank was forced to restore large amounts of cash. But there was no cash in the bank, only securities. And if the investor accepts the security, he soon discovers that only a few defaulting house loans are in that. Because even if he has now securities nominally worth of $2 million, these are different from the initial security he bought which may have contained 10 house loans, because of inflation now only 5 house loans are packaged in a $1 million worth security. If he cannot sell the 2x5=10 house loans on a higher price than he invested initially, he won nothing, only paid fees for bankers and brokers.

    As we have seen governments stepped in, beginning to buy these papers to supply the banks with cash. They are saying the values of these papers could be recovered by time, but I cannot believe this. Because the house price inflation was only a bubble, the current deflation primarily is a correction, not an effect of an economy in recession. So the government needs another bubble to redeem the taxpayer's money. Or it can wait for general inflation to reach that level, anyway in that case - compared to food and other commodity prices (which will be also inflated) - the loss will be huge.


    In response I wrote:

    I think the best way is to explain by example (a simplified one that shows you a mechanism how you can balloon banks balance sheets with loan to deposit ratio above 100%):

    1. A AAA-rated bank takes $100 deposit and decides to give $130 loan. It takes $30 loan from another bank and issues $30 AAA-rated securities. The lending banks got rid of $30 cash and got $30 "worth" of AAA-rated securities (counting for Tier 1 capital) which is not cash.

    2. Than a bank that got this $130 paid in, decides to give $169 loan. It takes a loan of $39 from another bank using the same mechanism as above.

    3. With every cycle increasing volume of cash (in proportion to the cash reserves) has to service each individual transaction, whilst increasing volume of papers is booked on the balance sheets. This process has exponential growth of increase of ratio banks balance sheets to cash on the market.

    3. If you iterate this process and there are trade imbalances, high commodity prices and cash oriented centres (offshore banks), as it is an exponential process, you quickly end up with some institutions (offshore banks, China, Middle East) holding huge piles of cash, whilst the other institutions have only AAA-rated papers that no one wants to buy for cash. This is a liquidity problem. (Interestingly proper offshore banks have very low loan to deposit ratios.)

    4. In this process as you were taking cash from reserves (replacing it with ultimately worthless AAA-rated papers) for some time you were actually increasing market liquidity inflating the prices of papers. However, as the cash found its new owners, the value of papers collapsed as no one is prepared to convert them to cash anymore.

    Please note that at the time there was a very active inter-bank lending. Therefore within each currency you can consider all the banks lending to each other as one big bank.

    Best regards



    In additional response I added:

    Maybe referring to this part of your e-mail will help me explain (together with my previous e-mail) how lending with loan to deposit ratio above 100% ruins the banking system.

    “In my interpretation when a bank has a loan-to-deposit ratio is 130% for example, we can exemplify this by stating that a bank has made loans in the value of $1.3bn and has deposits in the value of $1bn. If we assume that the total reserve requirements are 10%, then the bank has $130 million in cash or other risk-weighted assets (Tier 1 or Tier 2). In this case $430 million has come from borrowed funds. Not all borrowed funds are securities used only for pushing out more cash from the reserves by replacing it, since in the reserve usually there is not much cash compared to the volume of lending.”

    In this paragraph you do not state how many times a cycle: “deposit – loan – deposit” (with loan to deposit ratio above 100%) was iterated. As you keep lending round and round and round, the ratio of cash to risk-weighed assets keeps getting smaller (technically going to zero). As you are effectively pushing more cash on the market from the reserves, you inflate the valuation of such risk-weighed assets. And with every cycle the banks balance sheets, loans and deposits, keep ballooning.

    The end of this process, with loan to deposit ratio above 100%, is that there is not enough hard cash to service such huge balance sheets (that grew at exponential rate as a result of loan to deposit ratio above 100%). At that point, pyramid collapses, i.e. the risk-weighed assets go steeply down. The fact that you are trading the banks balance sheets, putting together and then slicing and dicing the products, spreads the effects in such a way that when the pyramid collapses no one is safe. Slicing and dicing spread the risk in a sense that it equalised it in the system, but with every deposit – loan – deposit iteration (with ratio above 100%) this risk was increasing, eventually getting to 100% at the point of collapse. So slicing and dicing did not help in mitigating the risk, but it was delaying an inevitable pyramid collapse, making the collapse much larger than it would have been otherwise.

    Banks ended owning with risk-weighed securities that no one is interested (or even have enough cash, according to inflated value at the top of the pyramid) to buy and very little cash. Ergo: banks are heavily undercapitalised and have liquidity problem. Precisely what the current crisis is.

    Your real estate example is excellent but it falls within the mechanism described above.

    Best regards


  12. The same reader as in the previous post responded privately:

    Thanks for your example. This somewhat clarifies for me your way of reasoning. But there is still something to argue about. What you have have described is capital depletion not money multiplication. When you create no reserves when giving out a loan, the ratio is still 100%, and cannot be above that. For if some fool buys these commercial papers, that money will be introduced like a deposit, not by multiplication. And in your example the bank that has given the $30 paid it in cash, which either originated in a deposit or in money multiplication that didn't exceed the 100% ratio. It is true that the 100% is trouble in itself because it will not diminish by iteration. So in the worst case (or fastest case) you have additions and then 100% multiplication, not a multiplication above 100% in an iteration.

    Consider for example each of us has a bank with $1million cash to loan out and $300000 in reserves. But if we both issue commercial paper and acquire high rating for these, we can interchange these papers between us and decrease our cash reserves to $200000 and we have $1100000 to loan out ($100000 more). But when we make loans the reserve requirements for $1 million or $1.1 million are the same in percentage. You can consider the money creation process of the extra $100000 in a separate thread, with the same ratio of the reserve requirement (or multiplication) as for the original $1 million..


    In response I wrote:

    It seems to me that there is not much difference between us (it seems to me almost all semantics). What I described is money multiplication which results in cash reserves depletion. As a clarification:

    Normally it would not be a pyramid building within the system, if a bank was "lending" with loan to deposit ratio above 100% provided:
    - there was a healthy general loan to deposit ratio requirement of, say, 87%
    - if a bank was overall at this ratio already and, out of $100 deposits taken, a bank wanted to lend out, say, 130 dollar then the bank could only lend a maximum $87 from these $100 deposits and would have to borrow a reminder from another bank to which the same lending principles with loan to deposit ratio would apply;
    - importantly if the other bank lent the first bank say $43 (to make $130 loan from $87 that the first bank would have been allowed to lend from its own deposits), it could not book $43 loan securities from the other bank as cash (regardless of risk factor put into it); considering the point above the second bank would also have stayed within 87% loan to deposit ratio;
    - this way the entire system, at loan to deposit ratio of 87%, would always have had at least 13% of balance sheets as cash reserves; this would stop oversupply of liquidity and a pyramid would not have been possible;
    - if a bank is allowed to book in its capital the other banks' securities as cash (even taking into account a risk factor) this bank acts as a cash printing machine for the first bank; this allows loan to deposit ratio overall for the banking system or at least a good part of it exceed 100% and this starts pyramid building at an exponential rate; the current system is a result of such process.

    To summarise:
    - loan to deposit ratio must always be below 100% for every bank but you do not count as a part of it money which is re-lent from a different bank;
    - the cash that stays in the bank resulting from 100% minus minimum required loan to deposit ratio must not be converted into any other security; it must stay in this bank as cash as a minimum reserve for deposits and cannot be used as security for anything else.

    I hoped that these conclusions were clear from my pyramid analysis.

    In contravention to these quite obvious rules, the financial world created a mechanisms using loan to deposit ratios above 100% that:
    - resulted in pumping out cash of banks reserves and moving it to countries with which the West had huge trade imbalances and to proper offshore banks;
    - resulted in ballooning banks balance sheets at exponential pace to a level of quadrillions of dollars;
    - resulted, once a huge amount of cash reserves was pumped out from the banks and relocated to places as stated above, in liquidity crisis (no more cash in banks) and collapse of value of securities (caused mainly by the liquidity crisis); as these securities were also replacing cash as capital reserves in this pyramid building process it resulted in banks being undercapitalised.

    All the above was always perfectly predictable (based on Cobham Thesis) if you allow loan to deposit ratio to exceed 100% in the system (which is only possible if you allow to consider securities, even if they are risk weighed, to replace cash in banks' minimum capital requirements).

    BTW, you may find it interesting that within my reasoning there is a need for one thread only. For example an interest paid to a bank on existing loans is, if it is to be used to be lent out, also treated as a deposit for loan to deposit ratio purposes. (Basically it is as if a bank was depositing its own money in itself first to lend it out.) This creates consistency of the system that guarantees that loan to deposit ratio would stay within its minimum and you will never end up with pyramid.

    I really appreciate your e-mails. They added a lot to the clarity of my arguments.

    Best regards


  13. Greg,

    Good luck proving your hypothesis that "trade imbalance with China to such a huge extent was effectively a result of loan to deposit ratio above 100%". I don't think you will be able to.

    As always in 'events' it is almost certain that interactions between different factors created the situation.

    Frederic Williams narrative begins with interest rates, and is just as plausible.

    The scale of the crash is an indicator of more than one cause.

    None of this is to, at all, undervalue the strength of your argument - I actually think it would be stronger if you allowed for the possibility of interwoven and interdependent causes.

  14. Alex

    Thanks for well-wishing, but I do not think it will be that difficult. In response, I refer you to my comparison of lending with loan to deposit ratio above 100% to AIDS.

    Lending with loan to deposit ratio above 100% creates very quickly (i.e. at exponential pace) massive overliquidity on the markets and this liquidity has to end up somewhere.

    I do not like writing, in a liberal arts style, "As always in 'events' it is almost certain that interactions between different factors created the situation". Whilst it sounds very reasonable, it is in fact quite meaningless. I do not exclude "different factors", I can only restate that lending with loan to deposit ratio above 100% was a sufficient cause of the current crisis. (In other words: even if other factors did no exist, this crisis would have happened anyway.)

    Frederic narrative is absolutely plausible. Indeed he is correct to a great extent in terms of looking into the root cause. Low interest rates made lending cheap. That created demand for credits that banks wanted to meet (to make money). In order to meet they started lending with a very high loan to deposit ratio. Therefore on one side you could actually argue that low interest rates are the root cause of the current crisis. However setting a very low interest rate is not a crime, whilst lending with loan to deposit ratio above 100% is (i.e. it is creating a pyramid scheme). As market demand, caused by low interest rates, is not a justification for breaking the law, I consider lending with loan to deposit ratio above 100% as the root cause.

    If you read into my arguments carefully, you should discover that my model is not in disagreement with comments I have received thus far (including yours). In fact it quite nicely takes them into account in a very systematic way.

    I greatly appreciate your critical comment, as any opportunity of a clarification adds value to my blog.

    Best wishes

  15. Hi Greg,

    I appreciate your writing. I have read a number of your articles over time. I do think that your degree of mathematical computation complexity is specialized. Have you ever considered doing a video with object lessons?? Or a presentation with graphs and such in a powerpoint type presentation?? Something to make things a little more clear to those who have difficulty grasping the theorum and the concepts??

    Keep up the good work. I just linked you on fb. I would love to see your blog go viral. How many hits are you getting??

    Thanks again.


  16. Laura

    Thanks for encouraging comments. I will definitely try to prepare Power Point presentations for the blog. It is a smashing idea. I am not convinced yet to video version, as I think I might not be the best person to do it. May be you could try this? I think your explanations of the concepts on my blog would be far more understandable than mine!

    To understand the current crisis is easy and difficult at he same time. Easy, as if you understand the characteristics of an exponential function (e.g. the massive qualitative and quantitative difference between lending with loan-to-deposit ratio above 100% and below 100%) you understand exactly why the current crisis was deterministic, predictable and why it is so deep and why, indeed, it is a result of criminal activities. Difficult, as for someone who does not has maths in a bloodstream, it may not be that easy. (People tend to think terms of “linear” relationships: that is how they intuitively approximate in their mind. That is why exponential concepts are not that intuitive.)

    Unfortunately if I did not write my blog in a bit technical, maths, terms, my blog could be considered as a set of emotive vacuous claims. But my blog is full of pretty strong claims and I use strict tools to prove them (although it is still simplified as much as possible).

    I have between 50 – 100 hits a day and average time of a visit is nearly 4 minutes. So my blog is not exactly viral, but taking into account that cyberspace is very crowded and my blog may not be exactly the easiest to follow, I think it is a reasonably good statistics. But I hope it will develop: if you spread a word around it will be greatly appreciated.

    Moreover I had a few direct private approaches from some eminent academic and experts…

    Best wishes


  17. Comment sent to the author by Stephan Olajide:

    IT was certainly a pyramid scheme. And allow me to add some colour to it.

    On a high level, we have commissioned the FED to manage the expansion of money/credit, i.e. inflation. We were all aware that our money system by Fiat depends upon the “wise” management of our monetary authorities and the reliance on the regulating mechanisms called RISK and INFLATION.

    Since 1971, the fall of Bretton Woods, we had no hard restriction on the creation of base money and soon thereafter Modern Finance expanded the toolbox to create Money/Credit outside the field of vision of the FED.
    How was it possible that one man could declare – and get away with - that markets are efficient and selfregulating without empirical foundations and just as these markets were being transformed by new theories and tools?
    From there onwards it wasn’t even clear anymore what would count as a loan, or a deposit. Leverage can be created synthetically. We all knew that and we all looked the other way.

    Why did it hold for so long? … already a valid question in the late 90ies. The short answer is our backstops, our regulating benchmarks were out of commission: Inflation and Risk.
    Inflation: No matter what kind of pyramid schemes we have been running, there are backstops. The creation of money/credit is inflation itself manifests itself rather quickly in our economies, which then would compel the FED to step on the breaks, according to its mandate.

    Not only did the FED choose to stare at a niche representation of inflation (CPI and later Core-CPI) also that particular segment was distorted to the downside by two major changes in measurement (1983 and 1998) and the outsourcing boom of the past 20 years. Literally, one reason the Ponzi scheme went undetected was that it went abroad and involved the global monetary system. Via the mechanism of Bretton Woods (US is reserve currency) money inflation bought imports (liquidity goes abroad) and funds were invested back into US asset markets. This inflated prices, values and as such collateral for credit. The system depressed goods price inflation (for a while) as manufacturing costs plummet and increased asset price inflation. The FED never considered asset price inflation.

    The FED also had a big hand in taking out the other backstop: RISK. The Greenspan Put guaranteed the system outright and with it removed risk from the originators of the PONZI mechanism to the taxpayer and invited them to take on additional risk (and leverage). In addition, market participants started to measure and value risk in such a way that blinded them from the growing risks in the system. In very simple terms, Price Volatility, the basis of Modern risk measurement played right into the FED policies. The liquidity provided by the FED and the system inherently reduced volatility and with it the perception of risk, which in turn allowed for greater leverage, creating more liquidity and the illusion of greater value and wealth.

    I agree with you 100% that it was a Ponzi scheme. The reasons it went on for so long and got so large were the complete corruption of all stop-gaps and regulating mechanisms we had counted on to keep money inflation and leverage in sustainable bands.
    The real scary part of it all is that not only are we sitting on an unprecedented mountain of debt, we also have to suspect that much of it was created with the use of very inaccurate risk and valuation models and thus is of questionable quality and cash flow earning capability.

    With best wishes


  18. I have received the following e-mail from a reader:

    Hi Greg,

    Well, I've just bumped up your 'average visit duration' somewhat, since it's taken me easily and hour to read and digest your 'Largest heist in history' blog! Anyway, I just wanted to say how impressed I am at your logic and reasoning, especially your patient and methodical treatment of (often very cogent) responses. I've read an awful lot about the banking crisis, but this evening I learned a whole lot more. So thank you.

    Being an average Joe myself, I have only one criticism of your piece. Where you state:

    "According to some estimates there are around $2 quadrillion worth of financial instruments (like securities) that cannot be redeemed due to the lack of cash in the system — so-called toxic waste."

    I think this figure ($2,000,000,000,000,000 ... probably) slightly discredits your thesis, since anyone who has read widely on this subject knows that the vast majority of this sum is tied up in back-to-back derivatives daisy chains. E.g. if a derivative of a notional $1 billion is insured with a 3rd party, who then insures it with another 3rd party, who then ... repeat 10 times ... you end up with an actual net uninsured liability of $1 billion (probably sitting in AIG!) but a whole chain of derivatives adding up to a gross $10 billion. Adding up these gross figures produces outlandish numbers (like 2 quadrillion) but the net liability is the only important figure here.

    Your $2 quadrillion sum is therefore probably grossly overstated. I vaguely recall Roubini suggesting a net $10 trillion or so. Which is still a big number of course.

    Whatever the case, your blog is hugely impressive and I thank you for sharing it.

    In response I sent a couple of e-mails summarised below:

    Hi Mike

    It is really difficult to get precise information since there is a lot of stuff going as OTC's. The Bank of International Settlements in Basel figure for officially disclosed operations of December 2007 was $1.144 qn and it was net outstanding securities. (It would have been rather discrediting for such a bank to do what you suggested I effectively ended up doing, as the figure would have been completely meaningless.) Have a look at former FT journalist Tom Foremski article: http://www.siliconvalleywatcher.com/mt/archives/2008/10/the_size_of_der.php So $2qn is basically a conservative top-up of $1.144 with off-the-official-record products.

    I also had feedback from really credible derivatives guys and no one questioned this figure downward. Indeed I got suggestions of up to $6qn.

    I think your logic regarding multiple "insurance" (on derivatives market) is mistaken. It is not a daisy chain. It is a situation whereby if you insured $1bn 10 times, you pay 10 times premium, if there is a default on this $1bn then, $100bn become payable. (And if you insured 100 time $1tn becomes payable.)

    It is a truly pathological situation if you allow multiple insurance since you distort the risk model and a default becomes a way making money. Saving a default of $1bn may actually save many more billions. This is one side to this set up. The other side is more sinister: I have already heard credible stories about hedge funds who buy into companies (like SIV’s) to take control then they insure their debt many times over (on the other end) and then pull the plug to make a lot of money. It is the same as if you insured your house, say, 10 times over and then burnt it. Good business, is it not? This is how financial markets work.

  19. ...previous comment continued:

    As an example, a standard home insurer does not allow you to insure you house twice (or many times in general).

    1. If you did it, then if your house burnt you would have made a lot of money! So would you make sure that your wiring is safe, or would you go on holidays and forgot to turn your cooker off?

    2. Insurers also re-insure with one another: so if you insured your house twice with two insurers, and they, within their portfolio reinsured each 50% of your policy with each other, effectively this operation would not have any effect if your house burnt. (I hope you see this.) And both insurers would have wrongly believed they diluted their risk.

    I have not started dealing with this pathology of multiple “insurance” on derivatives markets, but I think I should take it on-board on my blog.

    So it seems to me that the financial situation is far worse than you thought. I hope I convinced you. If not, please send me your counter-arguments.

    I am very grateful for the comments.

    All the best


  20. Greg, I commend your maths, your clarity and your humility. Thank you for frightening me substantially by waking me up to the serious state we are all in. What frightens me the most is that a few people know you are correct, a few more know there is a problem and the vast majority ( I am one) are carying on as normal, managing difficult circumstances as best they can in the belief that we will crawl out of this in due course.

    Can you now turn your tidy mind to the way the consequences of the pryramid collapsing could play out? I am not sure how mathematics will help, but a start might be to assess the rate at which Governments recognise that doing anything with this "alien form" has consequences they cannot anticipate. In the same analysis you might want to consider how quickly public loss of confidence in their Government's response leads to random and panic induced activity...

    That's the down side. Is there an upside that you can see?

  21. Thank you for studying my blog. I clarify my views on three levels:

    1. Existential level – it is a huge crisis. But people are still produce food, have and manufacture clothing, have dwelling to live in. There was not any huge natural disaster or some kind of famine. So, on this basic existential level, we are safe. However, unless something is done by the government, we may have to resign to the fact that we lost our investments, savings, and value of our possessions and on top of that we, and generations ahead, will be repaying huge debt. Such scenario may ultimately lead to instabilities and potentially to wars, but it is difficult to speculate on probabilities.

    (BTW, where did the money go? I suggest checking up the balances of offshore accounts. The banking system developed a model which is conflicting with the rest of the interest of free market economy.)

    2. Armageddon level – it might have been better to let the banking system collapse and start afresh with the government taking care of the most vital social interests. This is what I would have suggested. Such scenario was tested in Albania in 1996 – 1997. It is not too nice, but it provides closure and a springboard for recovery. At present, if we leave things as they are, we, as taxpayers, are controlled in the same way as loan-sharks control their victims: it is effective financial enslavement. And this is worse than one-off financial Armageddon.

    3. Crisis level – due to the scale of the problem (nationwide, global) and its character(conflict: the banking practices are in conflict with the interest of the free market economy, basically the financial industry developed and implemented a parasitical business model sucking money from free markets and taxpayers), it is the government that must step in. It is like a war or crisis conflict resolution (this time between the society/taxpayers and free market economy against the financial industry), which cannot be managed through free market and democracy. The government must have a plan (like during a war) what to do: clear objective, strategy, realistic well-staged action plan, etc, how to clean up the financial industry to get rid off their parasitical practices (and prosecute the perpetrators like war criminals: I sometimes make reference that there should be a financial Nuremberg trial of those responsible for this crisis).

    Once this is achieved then the government, like after a war, can return the country to free market, democracy, etc. However, thus far, the government lacks a proper diagnosis. They remind Ethiopians, with their archaic weapons, fighting Italians and Germans during World War 2. To watch it is pretty pathetic.

    Is there an upside? I think if we agree that in a long term history we as humans developed from disaster to disaster, from war to war, then we can see this as a part of our learning curve (in a very long time history window). But for us living here and now, especially for those responsible people earning not that much money but caring for their future and their children (responsible middle and working classes) it looks to me as an utter massive disaster with no upside at all.

  22. I don't have a quarrel with your thesis, but, as massive inflation seems inevitable (the only way nations can inject 200 times the money... is a la Zimbabwe, to print it) it rapidly reaches the point where fiat money is worthless. The fellow with a trillion Zimdollars salted away offshore can buy a loaf of bread today, and a slice tomorrow. How the sharpies made this work for them in Zim was to change out of the currency or to buy assets with it. How does having a few trillion stashed work if all the fiat money is depreciating? Surely they're buying assets?

  23. Expected high inflation is consistent with my pyramid model of the current crisis. Basically if you try to balance ballooned (by a pyramid scheme) massive balance sheets with cash on the market by printing money, you will end up with high inflation. This is pretty basic but outside of my model, yet completely congruent with it.

    With fiat money is a bit more complicated: with lending with loan to deposit ratio below 100% fiat money could be dangerous business but one can argue that it is risk we should be able to manage. With lending with loan to deposit ratio above 100%, fiat money is simply a vehicle of fraud (the risk is unmanageable). It always leads to disaster like the current one.

    Smart guys that used the pyramid I described to steal billions if not trillions of dollars in cash, are unlikely to keep cash. I would look at property of all sorts: real estate, gold, any commodities, long term credible contracts for commodities, ownership of natural resources, etc. These are basically things that high inflation will not depreciate very long term.

    If a fellow with a trillion Zimdollars 10 years ago, bought property then he would have done it rather well.

  24. Thank you Greg - it's a good analysis as I said. It might be noted that guys who really exploited the Zimbawe/Weimar republic money situation, were those for example who did not spend the trillion dollars to buy an asset, but who borrowed - using their existing holding as deposit, (say a morgage - paying 10 million up front for a 100 million dollar property, which they then own, and - as the currency grows zeros with hyperinflation - but their borrowed sum does not, they pay for with worthless cash in no time before the also huge interest payment can catch up. Expect hyperinflation when hoarded money from the offshore banks suddenly start providing deposits for a lot of property/assets (probably tied with a spike in price). But for most of us we will end either with debt slavery or hyperinflation impoverishing us. I'm not sure what the best defense is.

  25. I think we are on the same wavelength. With the current crisis, the question is not when it will end, but how it will end. The crisis of the 1930’s ended with the World War Two. I am not predicting anything now. I am simply pointing out if the history is anything to go by, we live in very, well, interesting times.

  26. Perhaps I have misunderstood, but it seems that governments lost control of the amount of money in circulation. Exotic financial instruments allowed companies to effectively print money and, as you indicate resulting in more more assets then there is money to purchase them.

    The current solution seems to be to inflate our way out of the crisis by printing more money. Isn't this solution just creating the next bubble/crisis (assuming that it even fixes the current problems)?.

  27. TexasDave: I think it is a pretty good brief summary of many issues on this blog. The point I would add: a lot of these assets are bogus. As if a homeless person gave you an undertaking (i.e. an asset) for a few million bucks. You may believe you will get it one day, but it is quite unlikely. BTW, thanks for reading it and if you think it is worth it, pass a link to it around.

  28. In my humble opinion your thesis is irrefutable. I read it as an elegant explanation of why so many of the weird financial bad things that have happened have had to happen.

    What bothers me is that if (when) the money pyramid collapses not only will our savings, pensions and financial investments become worthless but we will have no means of exchange. Division of labour and specialisation will be unable to operate. I myself doubt I could live off the land, and have no useful basic skills with which I could barter. I will not be able to eat (or heat) my house. Owning land, water, gold or barrels of oil would also offer little practical comfort.

    I also don't see the gain to the powerful 'insiders' if there is chaos. What kind of lifestyle could they safely enjoy?

    In your opinion could the pyramid be helped to collapse slowly enough for a system of sound money to be re-established, and would there be the will to bring this about by the people who have enabled the money pyramid?

    I would also be interested if you have an opinion on a the length of a particular piece of string: how long until the big blow up? John Law's fiat money pyramid lasted only four years. This one has been going for forty years already and is perhaps being steadied by a deflationary headwind.

    We are indeed living in interesting times. Perhaps we could enjoy it a bit more if it was happening to someone else!

    I wish you well.

  29. Allan, thanks for reading my blog and time taken to send me your feedback. I think I have addressed to good extent some of your points in other posts and comments. (Whether you agree with them or not is one thing, but I hope you enjoy reading them.) However you inspired me to write about a possible scenario developing which I will do within next few days as a new article. As holidays are ending, the banking life support government cash injection is coming to an end we have interesting things ahead of us... I will write a few words about it.

  30. Firstly, I’d like to say that it is a pleasure to read your blog – unlike much of the Blogosphere, you write exceedingly well, with good grammar and a higher signal-to-rant ratio than usual.

    But I do have a couple of points I have to take you up on.

    Firstly, I really think that describing fractional reserve banking as a pyramid scheme is not at all helpful. I know that the term “inverted pyramid” is often applied to a banks capital structure, where a very small amount of equity capital supports a huge (country-size in RBS’s case) balance sheet. But the terms “pyramid”, “pyramid scheme” and “Ponzi” scheme have well established meanings in finance, and fractional reserve banking does not fit their description. A key point of pyramids is that cash flows “up” the pyramid and then out of the scheme – it is extracted from the system. A second key point is that every pyramid scheme will collapse with probability 1 within a finite time – the money extracted from the system can only be balanced by inflows for a limited time. Barring bank runs or liquidity crises, fractional reserve banking does not have this property – it can continue to exist, with the inherent risks being maturity mismatches between assets and liabilities. The banking system is not a pyramid scheme, and describing it as such muddies the waters. The banks which collapsed did so in a different way to a pyramid scheme collapsing. Comparing Lehman Brothers to the Albanian pyramid schemes is very misleading. In the former, the money was “there”, it was just locked up in illiquid assets. In the latter, the money was gone.

    Secondly, your LTD argument has a rather large flaw. The most common set of numbers you quote is £100 deposits generating £137 in loans, which gets recycled as £137 of deposits and so on. Well, filling in the picture quickly shows why this runaway mathematical argument is flawed. In reality, £100 of deposits and £37 of other funding is lent by our example bank. This £137 goes out into the market, and is recycled as, on average, £100 of deposits and £37 of non-depository funding. Then the loop continues again. It’s the incorrect jump from £137 loans equalling £137 of deposits that makes it look like there is a runaway loop occurring.

    I have a couple of last, quick points to make. As a previous commentator alluded to, applying regulatory restrictions of LTD to be below 100% isn’t going to stop banks imploding when there are liquidity crises. Banks lend long and borrow short, and are always vulnerable to runs on deposits. A bank with an LTD well below 100% can still be finished off by a collapse in the short-term money markets. In fact, several firms that collapsed were not insolvent on a net assets versus net liabilities basis – but they were insolvent on a liquid assets against short term liabilities basis.

    Lastly, you stated that “Deposits, mortgages and business accounts are clearly non-toxic in principle.” That’s just not true. Large amounts of what are described as toxic assets are residential and commercial mortgages that are severely underwater, although that is partly because the press can be a bit casual with describing loan books as full of “toxic” assets.

  31. Andrew, first of all thanks for reading my blog and thanks for giving a critical comment. I also apologise for any “rant”. It is really one of those things one has to do when blogging to comply with a tradition. However my aim is, that – despite of rants – I want to keep my blog analytically correct.

    In response:

    1. I encourage you to read more of my blog articles as you seem not to have picked one of key points. I am NOT bashing fractional reserve banking. Some do-gooders, anarchists, lefties, etc also think like you do that I reject fractional reserve banking, but I do not. I believe that fractional reserve banking carries some liquidity risks but it is a controllable risk to a great degree. I am minded to accept (as I made it clear on my blog and I do not want to repeat myself) that we should live with such risks (like we cross the roads, fly the planes, drive the cars etc). However fractional reserve banking term implies that LTD is below 100%. Basically you “bank a fraction” which is 100% - LTD. When LTD is above 100% we do not practice “fractional reserve banking” anymore, but “depleting reserves banking”: LTD – 100% at each deposit – loan cycle is the amount of cash that the reserves are depleted by. I wrote a lot of this on my blog and I encourage you to read it. (For example this explains why banks, for a long time, could lend money for less interest than they paid on deposits and still were making profit on such operations For more please refer to: “Why banks are still not lending?”


    Importantly, for LTD below 100% MONEY MULTIPLIER is FINITE (e.g. for LTD 90% it is 10 so it is 1/10 fractional reserve banking). For LTD above 100% MONEY MULTIPLIER is always INFINITE (and as it grows EXPONENTIALLY to INFINITY it is a PYRAMID SCHEME). This means that a single dollar cash has to “service” ever growing at exponential pace and without an upper limit amount of dollars on banks balance sheets. This is basic maths.

    (LTD – 100% is a measure of bogus value creation that at first looks impressive on the balance sheets, but is a mechanism of liquidity crisis with probability 1 within a finite time. The mechanism of heist was, that based on that bogus value, real liquid value like cash was taken out of the system: a lot of it sits offshore, that not surprisingly shows no sign of any liquidity crisis.)

    Basically by suggesting that I criticise fractional reserve banking shows that you do NOT understand what I am writing about. Of course, FRACTIONAL RESERVE BANKING is NOT a pyramid scheme. It is DEPLETING RESERVES BANKING that is.

    I could stop there, but I will respond to other points (which are also addressed to a great extent in other articles on my blog).

    2. A pyramid scheme (which actually should be called inverted pyramid scheme) is a well understood structure occurring not only in finance and described by maths (complexity). By definition, this is any structure with an exponential growth from the initial point with base greater than 1 (e.g. 1 starting point, 2 base: 1 – 2 – 4 – 8 -16 – 32… 1 x 2^n). By Cobham Thesis it is intractable. If you present this structure graphically it looks like a pyramid hence the name. So it could be that “cash flows ‘up’ the pyramid and then out of the scheme” but there are plenty of other ways of using pyramid schemes to engineer scams and steal money. (And I do not want to give too many “ideas” to others, including bankers, how to get rich quickly and what else can be done.) Your example is one of many. A lot of people in finance do not understand basic maths – or pretend not to understand it - and they tend to use too simplified and distorted descriptions of very well known and researched phenomena, like a pyramid scheme, that is described by maths. You seem to have joined this distinguished crowd that includes the CEO of one of the largest and well known banks. For more information, please read: “Liquidity risk”:



  32. cont…

    3. I do not agree with your argument on lending £137. There is no such thing as non-depositary funding in a sense of LTD ratio: before money is made available as a loan it has to be “deposited” in one way or another as otherwise it would simply not exist. For example investment – wholesale is NOT non-depositary funding; it is a part of the same cycle as deposit – loan of circulating money but under a different name. For more details read my “Liquidity risk” article:


    If LTD is 137% that is what it is and, BY DEFINITION of LTD, it works how I described. What you describe does not represent deposit – loan cycle at LTD 137%. The best response to your point is in my article: “Example/exercise – how does it work?” (I use LTD 130% in this article). It gives you an example of use of, what you call, “non-depositary” funding in deposit – loan cycle, and shows exact mathematical points where your argument is flawed:


    It seems to me that your argument, about 137% LTD, could have been used by bankers to delude themselves that somehow lending with LTD above 100% would not lead to liquidity crisis with probability equal 1 within a finite time. However I believe that the guys who engineered this crisis knew exactly what they were doing, i.e. that lending with LTD above 100% constituted a pyramid scheme and a very effective tool to steal money (for example in a form of bonuses and other payments for impressively looking, but bogus, balance sheets like Lehman Brothers’; balance sheets were huge numbers in the system representing ultimately “illiquid assets”, bonuses were, not surprisingly, quite liquid: cash; not exactly too sophisticated fraud).

    Coming back to your statement: “Comparing Lehman Brothers to the Albanian pyramid schemes is very misleading. In the former, the money was “there”, it was just locked up in illiquid assets. In the latter, the money was gone.” If Albanian gangsters put into their pyramid schemes their promissory notes as guarantees for their pyramids balance sheets they would have been as liquid as Lehman Brothers assets. Let me put it this way: Lehman Brothers illiquid assets were, to a massive extent, bogus assets. They represented the size of a pyramid scheme, not a real wealth creation. (I also have a few things that I believe are worth good few million dollars: the problem is that at present no one is prepared to pay that much for them. Are they my illiquid assets and I can think of myself as a millionaire? So I guess I have the same type of problem as Lehman Brothers :-) Therefore I do not understand your point about being misleading. You seem to be quite happy to accept mark to market valuation if it gives results you like, but you reject it if it produces value nil of “assets” (calling it illiquid). You cannot have it both ways. (Again, “Example/exercise – how does it work?” article shows one of the ways how Lehman Brothers assets became bogus.)

    Lastly on that point, in the alternative, even if your argument on lending £137 was correct (and in my view it is NOT), i.e. it worked as you described, you are still describing a financial scam (and you seem not to realise this). Lending with LTD of 100% (which is what you describe) is also a scam leading to liquidity crisis with probability 1 within a finite time. (This is because that if LTD is 100%, money multiplier is INFINITE.) However this time it is in linear time rather than exponential time so technically it would not be a pyramid scheme, nevertheless still a very serious financial wrongdoing. You seem not to have realised but you presented also a “runaway loop” although with linear rather than exponential pace.


  33. cont…

    Now a serious analysis that you may regard as a rant (but it is not).Lending with LTD of 100% is called “NO RESERVE BANKING” as no reserve is generated in deposit – loan cycle and balance sheets keep going linearly to INFINITY. It is an ultimate intellectual disgrace that a huge number of bankers, regulators and financial journalists do not understand – or they pretend not to understand – that fractional reserve banking implies LTD below 100%. This is not only about generating 100% - LTD reserve at every deposit – loan cycle, but MAINLY about stopping generating a process that multiplies banks balance sheets to infinity (stopping, what you nicely called, “a runaway loop”). For that reason alone, I believe that bankers remuneration must be slashed massively, so they are pushed out of this profession, as the current cohort of bankers is grossly incompetent or (non-exclusive use of “or”) deeply dishonest. They do not deserve any pay. They must be made liable for the losses to the economy resulting from their grossly incompetent and criminal actions. For more analysis, please read: “Curbing City pay will give it competitive advantage”:


    This is not an emotive statement: this is a result of dry analysis based on merits. Do not blame me that it looks that bad.

    4. I agree that regulating LTD, keeping it safely below 100%, is not going to prevent all liquidity risks. It would simply be one of the tools to regulate market liquidity (alongside interest rates). As I wrote, fractional reserve banking carries risks, but I am minded to agree that we should accept it and learn how to control it better. As I explained, LTD above 100% is “depleting reserves banking” that constitute, by mathematical definition, a pyramid scheme that “will collapse with probability 1 within a finite time” (to quote you).

    To quote your criticism: “(…) applying regulatory restrictions of LTD to be below 100% isn’t going to stop banks imploding when there are liquidity crises.” This is correct in my view. Your criticism is misplaced on this point as you criticised me for views that I clearly do not hold. (It just shows your lack of understanding of the issues that I am writing about.) However keeping LTD below 100% would help preventing liquidity crisis in the first place, but it is not a GUARANTEE. Having LTD above 100% GUARANTEES that liquidity crisis will happen with probability 1 within finite time. That is why a typical notion of “stickiness” of funds (e.g. deposits) becomes vacuous as nothing is “sticky” if LTD is above 100%. For more analysis please read “Liquidity risk”:


    (I hope you got all the fine points of logical reasoning on that.)

    5. To clarify “Deposits, mortgages and business accounts are clearly non-toxic in principle.” By non-toxic IN PRINCIPLE, I mean there is a DIRECT real value behind them: deposits carry wealth already earned by a depositor, mortgages are underwritten by real-estate that indeed does exist physically, business accounts reflect a value creation of a company functioning in the economy. However they can be made toxic if they are circulated through a pyramid structure based on lending with LTD above 100%. Therefore your criticism on that point is misplaced.

    Once again, I invite you to read more articles on my blog, as there are more extensive answers there already. Some articles have a bit of rant, but disregard it, and go for the merits.



  34. Hi Greg. Really appreciated your blog. So the next question is given this mess .. what do we do about in terms of fixing the issue, and also protecting our wealth. Would you agree that we should expect higher inflation? Do you think that the central banks will have the courage to increase interest rates signficantly to battle inflation? Should we all just start buying gold:)

    Thanks again for your time.

  35. Hi Chinh, thanks for studying my blog. If you think it is worth it, please pass around the link to it. I have given some hints on my blog how, I think, it is possible to be a bit secure. The problem is that, in my view, the crisis can go in so many directions that it is impossible to predict. Another point is, if a great majority use the same recipe it is unlikely to work anyway. (Say everyone will try to withdraw cash and buy gold: a lot of banks will be "on the run" and will go bust and the gold price will go through the roof.)

    So my answer is: I do not really know. Conservative approach and diversity is my approach. But you will have to make your own decisions (at your own risk).

  36. Great post and your mathemathic reasoning is within the grasp of anyone who's ever studied maths in school. It just confirms my belief (and all historic evidence) that fiat money systems always come crashing down as people device ways of extracting profits out of thin air and it is only a matter of time for the wide public to realize that their money are worth nothing. What is your view by btw on the next couple of years and do you think that central bankers will be able to hold the system for long enough for people's confidence to come back again?

  37. Hi Dadam, Thanks for your comment. If you think my blog deserves it, please pass the link to it around.

    With regards to fiat money, I would like the readers to grasp a distinction:

    - with LTD below 100% it could be risky business depending on the level of LTD. With LTD 50% (money multiplier is 2) the risk is very low, with LTD 99% (money multiplier is 100) the risk is very high. It is a question that the public must answer how much of the risk we prepared to accept. Do we accept fiat money, as there are benefits, and how we are going to manage LTD (what levels in what circumstance)? In this context it is respectable position of both sides: those who do not accept fiat money at all and those who do (but they must make themselves clear on risk management side).

    - the key point about this crisis is that LTD was (is) above 100%; this is a completely different set up than one I referred to above; it is a massive scam pyramid scheme (which is fuelled by fiat money).

    I invite you to have a look again at these two dramatically different scenarios (LTD below 100% and above 100%): basically if you follow my blog it should be clear to you.

    This point is important: I doubt that the argument against at all fiat money will be won. Therefore bankers like to lump critics of fiat money (altogether) to lump with people like me who do not criticise fiat money, but simply point out that the system with LTD above 100% is a scam. This way they reduce clear common criminal activities (of running a pyramid scheme) to a philosophical debate (about fiat money as such). This way, thus far, they are quite effective in escaping justice.

  38. Thanks for the answer.

    I think that one of the main reasons for the LTD ratio to get as high as the current levels was the implementation of the Basel II accord esp. in regards to requiring big banks to calcualate their risk exposure on their own and then using the provided (by the banks) figures to calculate the reserve requirements. It is interesting to notice that tha first to implement those new "regulations" were also the hardest hit by the credit crisis and also that small banks that continued to value their risk using other firms were not in such a difficult situation. What are your thoughts on that?

  39. Thanks for comments.

    I agree, but as always in this area since it deserves a massive book, there is always something to add. In this case even if some banks were doing more conservative (i.e. realistic) risk assessment but were using mark to market approach their assets valuation was also affected by the massive bubble generated by lending binge. (They were also led to believe in bogus values of their assets.) And this binge can be seen in correlation between LTD and which banks were affected most.

    The fundamental sin is to treat anything that is NOT cash to be as good as cash. Cash is always underwritten by a state and a real economy. So in LTD cycles (where LTD has to be below 100%) a reserve kept (i.e. 100% - LTD) has to be cash (and it cannot be relent further even on interbank market).

  40. Recent e-mail exchange with a reader (preserving anonymity):

    A reader:

    “It is incorrect to look solely at loan to deposit ratio as most banks raise funding in the capital markets. This funding is either long term or short term, secured or unsecured. There is no difference between this type of funding and deposits apart from differing maturity types. By definition, loans to liabilities will be below 100% for banks with a positive equity book value. The problem with british banks in general was that the assets (loans) to equity was 30-50x which means a 2-3% writedown on assets renders the banks insolvent. This coupled with an asset liability mismatch is why all british banks needed bailing out.
    The money multiplier effect that you bang on about is equally applicable to non deposit funding types, and is therefore, by definition impossible to exceed 100% loans to liabilties (whilst solvent). The correctly identified pyramid-esque characterestics arise from the dubiousness of the solvency of the institutions. As we see time and time again in banking when leverage multiples expand and asset prices are inflated solvency is reinforced until expansion stops and the tide goes out so to speak breaking solvency rapidly.”

    Blog author’s response:

    “I do not really see a contradiction between what you wrote and what I
    write on my blog. I invite you to read in more detail (as you seem to
    believe that deposit applies to just a typical saver/depositor).

    For instance please read:
    http://gregpytel.blogspot.com/2009/08/liquidity-risk.html (In
    particular I refer you to: "Basically "investment – wholesale money
    market cycle" must be considered as a part of "deposit – loan cycle"
    for the purpose of loan to deposit ratio. And, if it were not, it
    would be perverse.") It seems to me that you consider the notion of a
    "deposit" too narrow.”

  41. A reader:

    “The ONLY way to get a loan to "deposit" ratio of >100% is to take your
    narrow definition of deposit because, as stated in my original mail, it is
    not possible to get a loan to liability in excess of 100% without being bust
    (Technically this should be loans cannot exceed liabilities plus equity
    value). Legally speaking there is a distinction between deposit and other
    type of unsecured funding, although their priority in wind up is technically
    pari passu even if practically not for political reasons.

    Uk banks loan to "deposit" ratios exceeded 100% because they were also
    reliant on funding in the capital markets through securitisation, and
    unsecured bonds. If you include these other sources of funding within
    the definition of "deposit" then you will find it impossible to get a ratio
    above 100% for a sustained period of time.

    Now it is slightly more complicated than that because of reserve
    requirements and equity capitalisation. Using a narrow example of a company
    with bond financing only, so that there are no reserve requirements, there
    is no upper limit on the size of the vehicle until participants refuse to
    buy that company's bonds. As a result such company can lend out what it
    receives and rapidly expand leading to an expansion in the money multiplier
    in the economy, due to the increasing leverage of the company as expressed
    through its net assets to equity ratio sky rocketing. This mechanism is
    essentially how British banks became to large and leveraged through a
    variety of unsecured borrowings, securitisations and other off sheet balance
    sheet financings, and when everything was ultimately consolidated it is
    clear that British banks were far far too levered on an assets to equity

    It is misguided to focus on loan to deposit ratios and "pyramid schemes"
    when the real point is leverage ratio's of banks increased to unsustainable
    levels backed by low quality assets.”

    Blog author’s response:

    “Please READ:


    Or an explanation in a simplified way: consider all the money coming
    into banks as "deposits" (as wide definition of deposit as more less I
    use). In my analysis investments are also deposits as well as money
    that ends-up on the wholesale market. If banks circulate this money
    with LTD below 100% they will accumulate substantial cash reserves.
    This is called "fractional reserve banking". Then the banks start
    lending with LTD above 100% using the accumulated reserves and booking
    some papers based on financial operations as reserves instead of cash.
    I called this "depleting reserves banking". That is why when these
    crisis started banks had enough capital "reserves" in non-cash form
    and very little cash. So this "capital" went down in cash value and
    banks were becoming insolvent.”

  42. A reader:

    “Yes that is a very simple process I described in my mail - it is the expansion of the leverage ratio of the balance sheet. That in itself does not constitute an "illegal pyramid scheme".”

    Blog author’s response:

    “As it is an exponential growth of balance sheets to the underlying
    originating figure, BY DEFINITION, it is a pyramid scheme. ( A lot of
    financiers, especially historian or anthropologist graduates, who
    cannot comprehend an idea of exponential growth - i.e. a pyramid - use
    too simplified and incorrect definitions of a pyramid scheme.)”

  43. A reader: “An exponential growth of balance sheets is not "by definition" a pyramid scheme unless a sufficient period of time elapses. In the limit any exponential process tends to infinity however the limiting case has NO place in real systems because a number of other processes occur before the limit can take place.

    Let us consider a system where banks starts at 10x leverage.

    Consider case A, banks go from 10x to 20x leverage and stop at this point
    due to regulatory restrictions. The expansion from 10x to 20x would have had
    an exponential component but was ultimately capped. The real world would see
    asset price expansion, banks would deliver higher ROEs and "growth" as
    measured through the absurd GDP measure would be boosted. It is likely the
    damage from the expansion ceasing at the point 20x is reached could be
    contained and may not necessarily lead to insolvent banks. There is nothing
    illegal about the balance sheet expansion.

    Consider case B, banks go from 10x to 50x. At some point the leverage ratio
    for banks has reached a point of instability, likely a lot lower than 50x.
    When an event occurs that temporarily halts increasing leverage then the
    perception of credit quality of banks assets deteriorates and with it the
    solvency of highly leveraged banks.

    Consider case C, banks go from 10x to 50x+ and are given unlimited liquidity
    from the central bank which they are fee to use without negative
    consequence. Here banks are stablised by the access to the printing presses
    of the central bank. With the increased stability they are able to book
    profits on new business and continue to expand the amount of the money in
    the economy at an ever greater rate which requires the central bank to print
    ever increasing sums of money. Now we reach a different sort of instability
    due to loss in confidence in the monetary system as the purchasing power of
    fiat money tends to zero.

    In any case expanding a balance sheet is not illegal (though perhaps it
    should be). Describing the process of balance sheet expansion as an illegal
    pyramid scheme is highly inaccurate although has some merit for the shock
    value it garners which is an excellent quality because it encourages people
    to think about how exactly banks works.

    Option C is much closer to the limiting case and could arguably be described
    as a legal "pyramid scheme" of sorts to enacted by the government that has
    yet to occur yet in the UK. Ever increasing amounts of credit and money
    printing are required to sustain an overleveraged system. We are in the
    first phase of this process whereby the government is attempting fix a
    problem of too much credit by extending more credit. The system is
    inherently unstable due to the amount of credit relative to the size of the
    economy and the destination is either to have a deflationary delevering or
    to continue to print money and extend credit until our monetary system goes
    the way of ALL other fiat schemes when loss of confidence in money becomes
    total and society practically disintegrates. The retards currently in place
    in Western central banks, particularly in the US and UK, are presently on
    course for the later but my expectation is that at some point economist
    thinking will change and we will enter the safer deflationary route.”

  44. Blog author’s response:

    “The name "pyramid" comes from the shape of a graphical representation
    of an exponential function with base greater than 1. Any scheme that
    that is represented by an exponential function (with base greater than
    1) is a pyramid scheme (by definition). For example lending with LTD
    above 100%.

    Leverage, say loans to deposits at any one time, can be quite modest
    indeed even less than one. But if it is a result of a pyramid scheme
    (i.e. a bank was lending with LTD above 100% for some time) than a
    money multiplier can be anything 10, 20, 100, or
    10000000000000000000000 (and quite quickly). There is no way of saying
    that just on the basis of leverage.

    Expanding balance sheets using loan to deposit ratio above 100% is
    illegal since it is a pyramid scheme and pyramid schemes are illegal.

    Pyramid schemes are illegal because they get out of control very
    easily, it is an unsustainable business model, basically it is a

    I wrote extensively on these issues on my blog.

    Let me quote you:

    "An exponential growth of balance sheets is not "by definition" a pyramid
    scheme unless a sufficient period of time elapses. In the limit any
    exponential process tends to infinity however the limiting case has NO place
    in real systems because a number of other processes occur before the limit
    can take place."

    You do not understand the notion of a pyramid scheme. Firstly its
    scale does not depend on time but on the number of iterations on a
    pyramid structure. Secondly if the number of iterations is small the
    scale of pyramid may be contained. So if one cycle of LTD of 117% on
    $1 happens in 10 years, this would be such a small pyramid of $1.17
    that it would not even matter for the financial system (extra $0.17 on
    $1 in 10 years). However if 220 cycles happened (on an initial $1 with
    LTD of 117%) in one year (i.e. a cycle per a working day on 1.17 base
    pyramid) then it would generate over $5.8 quadrillion. I guess you see
    the significant difference between the two.

    1. In both cases it is a pyramid: in the first case it is easily
    containable (but still a tiny pyramid).

    2. It is not a function of time but a number multiplication cycles.

    Hope it is clear to you and in any event to read my blog in more
    detail. It is all there already.”

  45. A reader wrote:

    “Responding to your last two mails, one of which is below.

    Most banks use loan to deposit ratio above 100% when they increase their leverage ratio and this is not "by definition" an illegal pyramid scheme when it is done for a limited period of time only. To show the absurdity of your arguments through counter example, consider a bank with no leverage at all just equity capital. If it makes one loan using part of its equity capital and accepts one deposit smaller than the loan it is by your definition part of an illegal pyramid scheme! The expansion of the money supply through the credit multiplier is of course an exponential process but key to the stablity of the system is that only a certain number of iterations are completed using discontinuous time, or more usually using time as a continuous variable the growth rate of the money supply tends to 0 or similiar after a sufficient period of time has elapsed. Given limitations on capital the exponential growth rate is always curtailed and indeed goes negative as we have seen in the previous cycle. It is your notion of a pyramid scheme that needs correcting because it would not be acceptable in a court of law and thus your allegations of illegality are without merit.”

    Blog author’s response:

    “It seems to me that in your example you proved an absurdity of your own arguments:

    1. Let's us put some figures in your example: "consider a bank with no leverage at all just equity capitalf (say, $10,000,000,000 cash). If it makes one loan using part of its equity capital (say, $9,999,999,999) and accepts one deposit smaller than the loan (say, $1) it is by your definition part of an illegal pyramid scheme!" Indeed, a very dangerous one.

    1. Let's us put some figures in your example: "consider a bank with no leverage at all just equity capitalf (say, $10,000,000,000 cash). If it makes one loan using part of its equity capital (say, $2) and accepts one deposit smaller than the loan (say, $1) it is by your definition part of an illegal pyramid scheme!" Indeed. However this time round and after one operations like this it is not a problem at all. But if a bank continues this (i.e. lending with loan to deposit ratio of 200% (in this exaple this $2 come back and a bank then lends $4, then $4 come back and a bank then lends $8), after 34 cycles the bank has no cash left.

    This is precisely what pyramid scheme is all about: a massive run away growth that may look inocuous in the begining.

    PS. I do not have my notion of a pyramid scheme: I use widely accepted definiton. (Do you know a different version of pyramid scheme in kids' postacard sending game?)

  46. Further comment from Blog's author to the reader referred to above:

    "You do not seem to understand that you can expand credit with fractional reserve banking (i.e. lending with LTD below 100%) to any degree. (With LTD approaching 100% you will get money multiplier goingto infinity.) I am not saying that LTD's above 90% are particularly wise, and of course they are risky. But they are NOT pyramid schemes (as the base for exponential function is below 1).

    When you expand credit with LTD above 100%, it is not fractional reserve banking but depleting reserves banking, which is technically and legally a pyramid scheme fraud.

    If you are from the finance world and do not comprehend such rudimentary basics (obvious to any half-competent A-level student of math), no wonder we are now in the depth of the financial crisis which was easily predictable (without any benefit of hindsight whatsoever)
    and avoidable.

    But I suspect that quite a few bankers completely understand what I am writing about. Indeed I believe this crisis was engineered by some of those guys so as to steal depositors' and banks shareholders' cash from the reserves first (that were built up for centuries) and then from taxpayers as the governments are complete cretins (and corrupt, thieves too) supporting this pyramid.

  47. A reader wrote (to this blog author):

    "You seem to failing to comprehend the basics which I have been hammering away at consistently in my mails. Lending in excess of 100% LTD ratio is a necessary part of LEVERAGE ratio expansion and it is leverage ratios you should be concerned about. It is ENTIRELY OBVIOUS that the process if taken to the LIMITING extreme is unstable and creates bubbles as money tends to infinity but as I have tried to educate you to the fact that there are limitations to what banks can do without government intervention that limits the "cycling" of funds. Indeed this is why the banking crises occurred - British banks were vastly overlevered and their asset book quality was questionable and so their unstable cycling of money began to go into reverse. The ponzi scheme nature of some elements of the housing market and the securities that backed loans made to those areas was also plainly apparent.

    Your comments on my example of a highly capitalised institution demonstrate that so far you have been unable to comprehend the basic point that it is not LTD in excess of 100% that cause the problem but the extent to which money is cycled. In practice a bank starting out with 10bn of fresh capital may initially lend at far higher than 200% (or even infinite % as it has taken no deposits) but the ratio would tend to a sub 100% figure as the target leverage was achieved.

    Getting obsessed by labeling banks an illegal pyramid scheme apart from being legally inaccurate is also missing the bigger picture. The real problem is the lack of discipline in a FIAT currency system with positive inflation rate targeting that leads to year after year of credit growth. This excess credit growth leads to a bloated financial system and a brain drain on our nations universities as many of the best graduates get lured by their greed into careers as financial intermediaries and speculators with other peoples money as opposed to doing real functions in the real economy. Our monetary policy is run by technocrats who ludicrously think they can make a positive difference to the real economy in the long run by using printing presses.We are now in a worse situation than two years ago as policy makers (technocrats and politicians) do not realise that in a overleveraged economy there is only a choice between deflationary deleveraging and hyperinflationary collapse as confidence in money is destroyed when further stimulus is desperately applied. The endgame is close. Solutions:
    -Rebase money to a basket and eliminate central banks
    -Improve the insolvency regime for banks to allow for orderly wind-down without excess damage to the real economy and change the nature of savings and deposits to reduce the asset liability mismatch which will reduce the likelihood of defaults."

  48. The blog author responded:

    "Your arguments could have been used by Albanian pyramid scammers in 1997. I repeat LTD above 100% is a pyramid scheme and pyramids are illegal. (It is nothing to do with any obsession but a conclusion made on the facts.)

    I recommend reading

    The problem with LTD above 100% is that it becomes a run away process very quickly. You think you control something but actually you do not.
    You may think you did not take this into extreme, but you are there already many times over. (Thus far you failed to explain how you achieve the systemic control you suggested that it is possible, not to get into extreme. Please provide a coherent set of equations. In my view it is possible in theory - and I can easily derive such a set,
    but you have a go - but in practice due to its complexity it would fail.) After lending with LTD above 100% you can get back with one cycle below 100% loans to deposits on your books, but you might have multiplied money by any arbitrary number (you choose it and I will tell you how to do it).

    I did not really make any comments on your examples (apart from the obvious that could have been omitted): I simply put figures to your example.

    As money is really about figures (not "reasonable" arguments), I would like to see your arguments justified by numerical examples and formula. Otherwise it is impossible to debate.

    Generally I agree with some of your ideas. It is not a personal comment but you fail to understand basic math. Finance is first of all about figures and mathematical processes (which are deterministic) that govern the behaviour of the balance sheets. Then it is about nondeterministic human behaviour that makes the entire system so
    complicated. (You seem to clearly fail the first part of it: so it is impossible to move to the second.)

    My solution is even simpler: enforce the existing laws and regulations on the pyramid schemes, i.e. bang up thousands of bankers, regulators and some politicians and confiscate their assets (including stashed offshore). After that you will get the next generation of financiers who will knew the consequences of theft and failure. This will attract quality people not some Oxbridge PPE's, historians and anthropologists, people who are good in finance not who are just greedy, thieving and good in personnel politics. They will find the solution as they would rather not share the sad fate of their predecessors."

    Accountability and liability is the key: it must be proportional to rewards (which in case of bankers are massive).

  49. Hello Greg,

    First I would like to thank you for presenting your findings in such clear, methodical, professional yet entertaining fashion. I am impressed by how easily understandable your arguments are and anyone with the slightest knowledge of mathematics and economics should be able to fully grasp the logic behind your arguments.

    But I would also like to thank you on a more personal level. After spending several hours reading though your blog (mainly because I read carefully, re-read sections several times over and do cross research), I reassured myself: I am not alone!!

    I don’t know what experience you’ve had with people when you addressed their concerns to them (please do tell, I wonder how your average audience is digesting what you tell them) but I can tell you about mine. It has been overwhelmingly negative and largely dismissive. This will be my first post and in my second I will ask a few questions and try to find answers to the questions that bother me about the current situation and the structures in place in the banking world.

    For years I have been exchanging ideas with friends and family regarding what appeared to be massive abuses of our market economy and what I later came to refer to as the “Gangster Economy”. I am neither a banker nor an economist although I have studied economics at university (here and in my home country of France) and my opinions were forged over the years using the most basic common sense, something I now know is in very short supply in the world. The reasons that lead me to see a Gangster Economy emerging was, as I see it, a complete breakdown of the rule of law in the corporate world (that includes respect for established regulations and you touched on that in your writings). This is the most dangerous development I have ever seen in my entire life (I am 34) because it can lead to failures on multiple levels. The very basis for freedom is the rule of law. Dictators and despots may not understand how extreme levels of freedom in a society can be achieved without chaos but I do: It is possible because we respect and strictly enforce the rule of law. It is the basis for society as we know it.


  50. As I became more vocal about my objections regarding the stewardship of our economy citing widespread evidence of fraud/profiteering/racketeering fuelled by unbridled greed which seems to have become a virtue nowadays (“greed is good” I once heard Gordon Gekko tell me), people around me started to look at me as a delusional conspiracy theorist teetering on the verge of madness. I have been called a communist too by people who mistakenly viewed my criticism as a wholesale rejection of capitalism and the market economy.

    You should have seen the look on their faces when I once told a few people last Christmas that I could, for the first time ever, see the possibility of World War III!! Some thought I had finally lost it while other smiled meekly as if I was making a provocative joke. But the reality I see today is very close to what I read in history books. Perhaps have they already forgotten the history lessons they took, particularly those on the 1930s. After all it has been many years and secondary school feels like another life. Or perhaps the majority of people chose to believe that WWII happened principally as a result of the Treaty of Versailles, a political event, ignoring the fact that the German economy had already substantially recovered from the Versailles Diktat induced recession and that the financial collapse and the Great Depression was the real determining factor.

    I spent most of 2006-2008 trying to convince my parents (and everyone else) not to invest in the housing market which I had identified as a bubble in a scale I had never witnessed before (not even in writings). Simple common sense alone lead me to this conclusion (for instance rental yields were lower than interest rates, a no brainer observation). I tried to be as persuasive as I could but to no avail. I sounded like a barking mad scaremongerer when I predicted riots on the streets of Britain once the Gangster Economy would collapse. In the fall of 2008, something finally gave way. I told my father: “The gangster economy has collapsed” and I felt civil unrest and systematic bank runs would soon follow. But none of that materialised. Instead world governments agreed to a massive “bailout” of the banking system with the people’s money. I was stunned! But I knew the people would be angry and would never let the government use the money they had entrusted it to spend on schools, hospitals and research to be pumped into the incredibly complex and fraudulent structures you describe in your research. I felt the Parliament, the very voice of the people, would never vote anything approaching the bills that allowed the bank to have free access to the public finances. But they did. Not only that, incredibly, they won most of the public over. I tried and to this day keep trying to convince people that Gordon Brown had not “saved the banks” (much less saved the world) but only kept a crumbling structure from collapsing. My observations are invariably met with shrugs of resignation. “What can we do, it’s the only solution”.

    It seemed to me the banks were always in power in this country. If the events of the last year have not convinced everyone of that, then I don’t know what will. It’s not uncommon for corrupt systems to have politicians acting as mere messengers for more powerful people. In Iran, it’s the church. In many countries, it’s the military. In our western democracies, Britain in particular, it’s the banks.


  51. Like I said in my first post, the most dangerous and disturbing element of this crisis is the breakdown of the rule of law. We have an incredibly rich body of laws and regulations, yet we seem to allow certain organisations to by pass them at will. Compliance seems to be the art of circumventing regulation. We hire compliance people, not in order for us to make sure we follow the rules but to create structures that have the appearance of compliance but which in fact are illegal in all but name, the same way we used to consider accountants people who counted money that was there as opposed to counting money that does not exist.

    And whenever a crisis emerges, we keep hearing politicians and members of the public, urging our parliaments to legislate while in fact legislation has been here all along. We seem to be very good at legislating over and over again but less apt at enforcing existing legislation and swiftly closing loopholes.

    This is the work of the regulators. But it seems the FSA has allowed banks to run their business whatever way they saw fit. Did they offer no regulation or complicit involvement? So real the question becomes can we trust the regulator? If we can’t we have a problem that touches the very heart of our democracy.

    The other aspect of this banking crisis that I find baffling in how dodgy assets can gain so much value when clearly some are barely worth the paper they're printed on. I would have imagined that ratings agencies would be on the case and their work would allow us to see the true value of all that securitised cash and in so doing would give a clear and transparent risk assessment. Where are they failing? Why?

    As for governments , they seem unable (unwilling?) to let the free market do its job of purging dysfunctional organisations. Maybe this isn’t all that surprising since government is often seen as the one restricting free markets. However our recent governments have warmly embraced the free market, yet when it comes to letting the invisible hand do its work, they act very differently than what their rethoric suggests. One obvious reason is that the people (the electorate) are both kingmaker and executioner. I advocated the collapse of any financial institution that was unable to stand on its own (although some degree of time and support would be given) but would the public punish the government for doing what free market dictates and what seems to be the only sustainable solution?

    I have also noticed that ever since the bursting of the dot com bubble, policy makers have done everything in their power to make sure the profiteering winners of yesterday would not be today’s losers. Central banks have helped (or try to help) Wall Street keep its winners by sedating the public with low interest rates and unlimited credit creating the real estate bubble that we know. They clearly are responding to the current crisis in the same manner. Can they forever avoid creating losers?

    Another interesting observation I made in 2008 was the rapidly increasing savings rates the banks were offering in the run up to the financial crisis. I spent some time on price comparison sites looking for the best saving rates and at some point in early 2008, they started accelerating to seemingly incredibly high levels. My bank guaranteed a saving rate at 1.5% above the base rate I think (a steal I though) but it was only a matter of time before I realise it paled in comparison with the much more generous rates offered elsewhere (I remember one bank offering 10% just weeks after HSBC came up with their 8% offer). I often wondered how high they would go. In retrospect this ominously reminds me of your Albanian gangsters undercutting their competitors with ever increasingly juicy deals.

    If we are unable to answer questions regarding the reason our governments, our regulators, our ratings agencies and broadly speaking our elites failed to, not only spot the problem, but also inform the public and take all appropriate action, one may wonder if any of those institutions can be trusted.

  52. Below is a comment received from a blog reader (published anonymised):

    Greg, understandably, perhaps, nobody comments much about the people. Occasionally one sees the bankers described as fraudsters, but not with any great conviction. Let this ancient (and two decades retired) banker then attempt to draw a banking scene for you that may help people to understand the extent of the fraud and its deliberate nature.

    Let me imagine that three or four years ago I was the CEO of, let's call it, the [...] Bank. Let's accept that I am not an economic imbecile (which is yet to be proved)and that I am astute enough to have got the job in the first place. In my imaginary scenario my treasurer resigns and I have no one either in the Treasury or the organisation overall, with whom to replace him. My problem is earth shattering. I have got a risk asset to customer deposit ratio of, say, 110%. I have yet to face anything like this in my life. I need someone with enough nous to be trusted to be able to do a testing job, but he must not have too much nous. He must have no background in banking and no understanding of it. He has to be young and lacking in experience, but not so young that he cannot talk the talk. How do I instruct the headhunters? How do I describe to them the sort of chap I have in mind? "Fairly
    good with numbers but an utter nerd in all other respects"? That will get me some funny looks and might set tongues wagging. It has to be a big step up for the individual, if I can find him, so that he is so grateful to me that he will not be asking questions. Oh dear me, how am I to find him?

    That might strike you as far fetched, but it isn't. Besides treasury staff, there are risk asset managers, internal inspectors, funds managers, traders, to name but a few, and their numbers multiply when you take in the full banking industry. They couldn't all be kept quiet with bonuses, could they? I have to deduce that the banks recruited an awful lot of unquestioning nerds. I have to deduce that anybody applying for a job who had studied banking history and even the most basic economics, even at night school level, was automatically disqualified. I also have to deduce that all morality had sunk in deference to the bonus culture. Sadly I also have to deduce that almost every bank CEO and bank director and hundreds of senior banking managers in the City, excepting only those who can prove mental incapacity, should long
    ago have been prosecuted.

    For me, suffering from the outfall of all this, there is just one bright spot. I can take some reflected glory from the fact that, at a mere eighteen years of age, with only three years of banking behind me, I could have spent a mere ten minutes with any one of several bank balance sheets of the last few years and have remarked to a more senior colleague, that it was time to call the police, while nearly fifty years later this was beyond the ability of the Governor of the Bank of England, or of the absurd F.S.A.

  53. A fascinating read providing an insight which explains many questions in my mind.

    The only question I have is about the actual figures regarding the Loan/Deposit ratios reported by the "Council of ..." this and that. If these people are being supervised by the FSA which itself could not figure out the problem, and that the data can be misrepresented, then how can one be sure whether these figures regarding different L/D ration of different banks means anything particularly in the finer details, upon which all arguments are based?

  54. Sam, a very valid point, but not necessarily critical. This is my guts feeling but I have to think about it. Thanks for that. In the meantime I suggest reading a bit more on the blog especially on money multiplier. In my view this is were the crux of the crisis is. So if the data is even barely accurate my analysis is still very likely to be correct.



  55. This 10 min video Explains the simple Scam Quite well I think.
    All hidden from the publiby Complex Sounding Economics Gibberish.


  56. Adrian, thanks for reading my blog and posting the video. Below is my comment.

    This video is critical of fractional reserve banking, i.e. lending with loan to deposit ratio below 100%. Whether it is good or bad (as it certainly carries risks and there is also a question who should benefit from this) is a matter for a legitimate social debate. However it is legal. The current crisis was caused by banks lending with loan to deposit ratio above 100% (which I called depleting reserve banking) which is a pyramid scheme. Highly illegal: technically infinitely much worse than fractional reserve banking. This is not a matter for social debate but for investigators, prosecutors and courts.

    In my view introducing (normally a legitimate) debate on fractional reserve banking only helps criminal pyramid purveyors. They look not as criminals (who they are) but bankers who were doing legal things that simply did not work out and at worst that can be criticised.

    I really wish people understand the fundamental difference between lending with loan to deposit ratio below 100%, i.e. fractional reserve banking, which is legal (albeit may be criticised) and lending with loan to deposit ratio above 100%, i.e. pyramid schemes, which are highly illegal, and whoever does it should be prosecuted.

    In my view such video whilst being critical help criminal financiers.

    I hope you will reflect that the situation is far (technically: infinitely) more worse than you think.

    Please send link to my blog around if you think it is worse it.



  57. Greg,

    many thanks for your original post and subsequent explanations. I have found them utterly fascinating and completely believable.

    I am not a Banker, Economist, Analyst or any other such thing, but it occurred to me that there are similarities between LTD > 100% and LTV lending > 100%.

    What is the first area of Lending that Banks cease doing when the economy declines ?, LTV >100%, why is this .... because it is suicide.

    Providing a loan at an LTV in excess of 100% creates an excessive leverage and can only be justified if you think that Asset prices will continue to rise at current levels. When those Asset prices fail to rise at sufficient levels, or much more horrifyingly drop, the whole bubble bursts and the ensuing credit losses are huge.

    As stated I am not an economist or Banker -- but to me, there would seem to be a direct correlation between the risk associated with LTV and LTD ratios above 100%. They both overinflate the market and create excessive and effectively unsecured risks.

    It is interesting to me that our august Financiers have managed to spot that LTV >100% was suicide and hence stopped providing them, but that they could not make the quantum leap, that by operating with LTD >100% they were essentially operating the same practice for themselves.

    No doubt a torrent or abuse will follow, relating to my complete misunderstanding of the concepts of Lending -- but from my laymans chair, this appeared to be valid.

  58. Layman, thanks for reading my blog. There is indeed a relationship between LTD and LTV ratios. From the pyramid perspective, lending with low LTD (below 100%) prevents technical pyramid. However it is possible to lend with high LTD ratio and low LTV ratio as high liquidity through high LTD ratio will drive value high, keeping low LTV. So “assets” will look worth a lot. This will last until banks run out of money as with lending with LTD above 100% it is inevitable. At that point liquidity crunch will happen and “assets” value will collapse. So what appeared at a time for granting a loan as low LTV ratio (how sweet), when is recalculated will become high LTV ratio (toxic). This is what actually happened at the outset of this crisis making the banks undercapitalised.

    So whilst keeping low LTV ratio is very important, it is not in itself that sufficient mechanism to avoid pyramid schemes or a liquidity crunch.

    BTW, Lord Turner of FSA does not understand this. See: “The Turner Review” - http://gregpytel.blogspot.com/2009/04/turner-review.html

    Maybe some financiers do not understand such maths basics. They are criminally negligent (or people who put them into such positions are criminally negligent). But some definitely do. They are real crooks who organised this massive heist: drained the system out of liquidity making massive bonuses, of course in cash, in the process.

    The causes of this crisis are trivial: common criminality and criminal negligence.

    If you think my blog deserves this, please send around a link to it.



  59. Greg. Great job. Your clarity is very helpful.

    I have an anthropology background and take great interest in the history of the present from a anti-colonial point of view (anti-colonial is a term used by Aime Cesaire, where he connects the process of colonialism to the modern inequalities between the European and North American society and the rest of the world. In effect saying globalisation is Imperialism by another name).

    My question is this: Your explanation of the crisis which i think is one of the best i have read, is for me a mechanism in the expansion of what Marx called the contradictions of capitalism. Some group gets richer, inequalities between that group and the rest of the world increase, provoking a process of pauperisation and a swelling of poverty around the world. Why do you think governments did not let the banks fail and protect them in the way you suggest in terms of the social safety net of pensions and deposits, etc? Is the nature of modern democracy to support the robbery and highly illegal pyramid scheme? And if there is any truth to these last two questions does that not mean that political options will always be fruitless and what we await is the inevitability over the coming years and maybe decades of violence against the state and those it supports? Sorry for the fear mongering but such thoughts connect to other wider issues like a more general militarisation of everyday life and the promotion of fear and insecurity within the general populace by the media, the state and other arms of what might be term the neo-liberal architecture.

    I have already passed on your link to others and am looking forward to reading other articles youve written on this blog.


    Dylan .

  60. Dylan

    Thanks for reading my blog and especially for passing around the link to it. As to your questions I have to disappoint you: I do not have answers. Of course I have some views but they are as good as anybody’s. They should be transpiring from my posts, but I do not think they are any special. (It may surprise you but generally I would describe myself as rather laissez faire, right wing, but compassionate conservative with socialist elements of Scandinavian approach to society.)

    What I am trying to achieve with my blog is to convey a more strict understanding of the reality of this crisis. I.e. there are some underlying objective factors of nature that we cannot really beat it, and there are some subjective factors of perception, values, etc.

    For example, a lot of readers get mixed up about fiat money and fractional reserve banking (lending with loan to deposit ratio below 100%) v the causes and mechanism of the current crisis. The former is a matter for a social debate and it carries liquidity risks. But there are also benefits of it so there is a social question whether as society we accept a risk of fiat money and how we share the benefits. In this context the social views are important: laissez-faire v redistribution, etc.

    The current crisis is well beyond it. It is not a failure of capitalism or free market. Nothing to do with it. It happened because financiers (politicians, regulators) organised fraud by allowing and doing lending with loan to deposit ratio above 100% (which I called depleting reserve banking). This is a downright fraud, a pyramid scheme, that guarantees liquidity crisis, a system failure. It is an objective fact regardless of political persuasion or social views.

    I would really like to stop my analysis at this point. Of course the issues you raised are very important for public debate (and always have been). However I do not want them to become a smokescreen of crude common criminality of the financial industry. Let’s say: we may differ in our views on economy or society but, I hope, we both agree that thieves are thieves so they must end up in jail and their wealth confiscated. I think this is a common denominator of decent, honest people.



  61. Greg, your response is fair enough. and yes, i do agree thieves are thieves. As such i do not think our differing starting points on these issues mean we do not reach the same destination. In fact it is such conclusions and dialogue that is needed to make visible the more subtle mechanisms involved in the robbery you describe. Things the anthropologist might claim are the reconstitution of racism and war as elements in the destruction of social bonds and the notion of maximising human capital (individuals in competition with all other individuals with no limits). I am not against capitalism. I believe a socially minded capitalism is the best system available to us. However we have long strayed from such a form and i would suggest part of the larger heist success was enabled by a transformation of the social and the recruitment of civil society so it became powerless to stop such theft or the state acted contrary to it.

    Keep up the good work. There is much to learn from your analysis.

    kind regards


  62. Greg

    great job. this has added nicely to my understanding of where the world is now at.

    I highly recommend these other bits of info/knowledge, if you have not yet come accoss them, as they have also substantially helped me piece together the puzzle:

    -The Great Crash of 2008 by Ross Garnaut
    -Irrational Exuberance by Robert Shiller
    -debtdeflation.com by economist Steve Keen
    -periodicals by Chris Leithner @ Leithner.com.au

    I would like to make a few comments:

    Ross Garnaut's book does an excellent job of describing the gfc situation as having been caused by several issues (in what i consider a multiple model framework encouraged by the likes of Charlie Munger).

    on that note, greed played a large part in promoting the lending problem you describe, and the majority of participants acted with a short term focus (on their next bonus) and not with a long term focus - i.e. how could this all end. As everybody was generally getting wealthier it felt like no harm was being done. As such I believe they acted stupidly but not with criminal intent as you describe. maybe there is a case for not acting with 'due care'?

    further, the situation got out of hand because a substantial part of the lending was against real estate assets. everybody observed the real estate values rising (in actual fact, their price, NOT their values) and while the game continued, no one got hurt. Shiller's use of the term 'animal spirits' to describe those who enjoyed the property related gravy train says a lot about how human nature played a massive part in this. i.e. again, while i accept your description that 100%+ lending was/is the critical problem, for a period (at least), it would i think, be difficult to recognise it as the cause of the asset price inflation and not the other way round.

    Once this concept becomes clear however (i.e. cheap and easy debt drives the property price) the enormity of the problem becomes clear.

    I have added steve keen and chris leithner as recommended reading, as both take a non-mainstream economist view. professor keen points out the enormous rise of debt relative to gdp in the developed world and how unsustainable it is, while Leithner maintains (and explains) his view on things based on his belief in 'Austrian' economic concepts, and how our current ways will come back to haunt us.

    while not an economist myself, i find leithner and keen's explanations very logical, much like your analysis.

    Finally, i read a research piece by Pivot Capital late last year (available from their website) that has me quite concerned about China. In my view, China is one of the only things keeping the world economy going at the moment, and the report highlights that it too is likely now entering the final stages of a house of cards act, many thanks to the chinese government.

    if the report is wrong, maybe the world will pull through, albeit in an ugly fashion, with much of the developed world experiencing Japan style deflation, while China picks up the mantle from the US in leading the world economy.

    If the report is correct and china is actually up the creek without a paddle... who knows where we will end up?!?

    Meanwhile, i observe this all from Australia, where china's demand for our resources keeps our economy afloat and our exchange rate high so that we can still (barely) afford the repayments on our properties that did not fall with the rest of the developed world, and are paid for not with our own savings in the bank, but with money borrowed from overseas. :(

    Meanwhile, mainstream media continues on its 'property shortage' fixation for justification of further 5-10% year to year price rises.

    (my apologies for the rant, it has been good to collate some thoughts though!)


    Justin S

  63. On a website iTulip, a user ThePythonicCow posted the following comment critical of the article above (http://www.itulip.com/forums/showthread.php?p=145223#poststop):

    iTulip High Commissioner, Select Premium Member

    Join Date: Sep 2008
    Location: North Texas
    Posts: 2,844
    Re: BART Gets Lew Rockwell Shoutout!

    Originally Posted by Diarmuid
    To my mind this is a demolition job, this is why I believe so, ...

    While I agree, I also disagree.

    First of all, that gregpytel blog you linked does a poor job of making the case, in my view. That blog starts off with the usual explanation of the fallacy of reserve banking, in which banks get to lend out more than is deposited, especially if their reserve ratios are allowed to collapse to little or nothing. However that explanation is itself based on the fallacy that banks create loans out of deposited money. Professor Steve Keen has done an excellent job of showing that this is backwards. Banks create debt out of the dual entry bookkeeping recording of the ostensibly balanced trade of present money for future income. Money is just one of the several forms, along with checks and bank statements, in which that money is manifest. Physical cash is created and destroyed on demand, like carnival ride tickets, to track monetary credit. Keen has shown that the money supply increases -after- debt growth, with a lag time of several months.

    Second, the exponential problems of monetary growth are not the primary relevant limiting factor. In a debt-based monetary system, the essential limiting factor is the ability to continue making the payments on the debt. Debt is just future income made manifest. When your debt payments exceed your income, you must default (after perhaps a temporary splurge of "digging the debt hole deeper.") The exponential problems exist in theory of course, but are usually presented more to impress the naive audience than to properly educate them.

    Let's say I take up exercise again and find that with proper training I can increase my vertical jump by one per-cent each week. I then sit down with my beloved HP-11C hand calculator and calculate that since I can currently jump one foot high, therefore I will be able to jump a quarter of a million miles over the moon (I'm a cow, remember ) in another 40.59 years. Expressing outrage over the impossibility of unbounded exponential growth is impressive here, but does little to explain the simple physics, biology and historical record (not to mention my remaining life expectancy being less than 40 years ) which tell me that even a frisky young heifer cannot jump more than a few feet high. I'm no puma, and even they can only jump at most about 15 feet. It is those limits which will confine me, not any particular exponent.

  64. below is a continuation of the previous ThePythonicCow comment:

    Debt, even for the most frivolous purposes, is manageable if you can readily afford the payments. Debt, even for the most upstanding and productive purposes, will default if you can't afford the payments.

    Debt based monetary systems (money comes into existence as one half of the double entry bookkeeping transaction of creating a loan) are not theoretically guaranteed to blow up. Rather (like seemingly every large scale human endeavor) they so far at least have always had instabilities that eventually led to that outcome.

    The blog post a bit later on states:
    According to some estimates there are around $2 quadrillion worth of financial instruments (like securities) that cannot be redeemed due to the lack of cash in the system
    That's nonsense. That $2 quadrillion figure is an estimate of the total notional value of all the derivatives, swaps and other such exotic (and a little bit more ordinary) paper in the system. There is no scenario in which they all redeem, because many of them take positions that hedge opposite outcomes. The circumstances under which one derivative redeems would cancel another. Besides, they don't redeem in "cash." If all else fails, they either default or they redeem (as us Americans have been learning the hard way) in claims on future tax collections and in inflationary devaluation pressures on the currency.

    But ... I'm afraid I'm lapsing into "scoring debating points" mode here, not optimizing either amusement or elucidation.

    I'd look to other sources for a more accurate and nuanced explanation of what happened. For example, see Hoodwinked: An Economic Hit Man Reveals Why the World Financial Markets Imploded--and What We Need to Do to Remake Them by John Perkins for another angle on this. We (the corptocracy usually thought to reside in the U.S.) has been shoving it's corruption down the throats of other nations for many decades now, stealing their wealth, their resources, their labor, and their future income and tax revenues. Now it's -our- (the U.S.'s) turn, along with some of our "best friends."
    All that's needed for the triumph of evil is that respectable men dismiss the unseemly too quickly.

  65. Since I am unable to respond on iTulip blog my response to ThePythonicCow is below:

    Thank you for criticising my blog as it will, hopefully, help me to do a better job. With respect you do not appear to understand my analysis:

    1. You wrote: “That blog starts off with the usual explanation of the fallacy of reserve banking, in which banks get to lend out more than is deposited, especially if their reserve ratios are allowed to collapse to little or nothing.” This is not true. I make it clear that reserve banking is not a fallacy unless you start getting close to LTD ratio 100. Lending with LTD above 100% is NOT a reserve banking (i.e. fractional reserve banking). You seem to have completely missed the critical role that LTD of 100% plays in lending.

    2. You wrote: “Second, the exponential problems of monetary growth are not the primary relevant limiting factor. In a debt-based monetary system, the essential limiting factor is the ability to continue making the payments on the debt.” This shows your complete lack of understanding of “exponential problem”. This problem may be a primary limiting factor (and in the context of the current crisis is) and in my analysis stems not from ability to pay but from money multiplier (MM). You cannot have a liquid financial system with MM running extremely fast to infinity. In practice ability to repay gets reduced (at exponential pace) to zero, as there is no money going around to repay the debt (since MM keeps going with exponential pace to infinity).

    3. You wrote: “That $2 quadrillion figure is an estimate of the total notional value of all the derivatives, swaps and other such exotic (and a little bit more ordinary) paper in the system. There is no scenario in which they all redeem, because many of them take positions that hedge opposite outcomes. The circumstances under which one derivative redeems would cancel another. Besides, they don't redeem in "cash." If all else fails, they either default or they redeem (as us Americans have been learning the hard way) in claims on future tax collections and in inflationary devaluation pressures on the currency.” With the last sentence you exactly proved my point. Thank you very much. Besides you put so much of your own representation into your statement that I did not write or imply that frankly you really commented critically upon your own statement not mine.

    If you understood my analysis you would have realised that it proves that with LTD above 100% money multiplier grows (at exponential pace, i.e. very fast) to potentially to infinity. The rest are basic consequences of this. It is not just an academic curiosity in the same way as adding one pound weight onto a bridge every second is not an academic dilemma only: it will eventually lead to a bridge collapse.

    Your statements like “Debt, even for the most frivolous purposes, is manageable if you can readily afford the payments. Debt, even for the most upstanding and productive purposes, will default if you can't afford the payments.” are correct but trivial to the point of being vacuous. The point I made was that a money multiplier growing very fast to infinity (which an inevitable consequence of lending with LTD above 100%) guarantees liquidity crunch and this means, inter alia, that ability to repay debt gets reduced very quickly (to zero at the limit).

    Thanks for your comments anyway: I do not take it as point scoring but a constructive criticism. I will try in the future posts to be clearer. Although I must admit that it is impossible to explain these issues to someone without good understanding of mathematical background.

  66. ThePythonicCow on iTulip wrote further (http://www.itulip.com/forums/showthread.php?t=13998):

    "Pytel does expound at length on a mechanism of fractional reserve lending that (Professor Steve) Keen has largely discredited."

    Clearly ThePythonicCow does not understand the blog. This blog considers that fractional reserve banking carries risk and whether it is considered as discredited or not is down to individuals. This blog deals with lending with LTD above 100% (which depleting reserve banking) proving that it is a pyramid leading to liquidity shortage.

  67. this kind of blog always useful for blog readers, it helps people during research. your post is one of the same for blog readers.

    Thesis Papers Writing

  68. Andrew G, an Imperial alumnus and a Project Manager at a major telecommunication company wrote to me by e-mail:

    Mr Pytel,

    I have read your blog and would be happy to comment therein but find I have to join something – I am not a great joiner of things, I’m afraid. Herewith my thoughts, which I am happy for you to post if you wish:-

    I disagree with the entire hypothesis that we have witnessed a Pyramid Scheme. You have repeatedly said that lending ratios over 100% must inevitably lead to an exponentially based failure. You have not explained why this is so - indeed, one of the contributors to the blog has suggested that a one off departure over the 100% mark can be stopped and no harm done.

    I think the issue is that lending over 100% of deposits would lower the reserves of the bank. Continuing to do this will, inevitably, result in the bank having no reserves to call on and just one failed loan will make the bank insolvent, unless the bank borrows from elsewhere, which results in reserve ratios that tend to zero.

    As one other contributor has said, Northern Rock failed because it had lent long term using short term money borrowed from the open market place and short term money became unavailable for a number of reasons. Firstly, many banks had been engaging in depleting their reserves, secondly, the quality of the assets backing commercial and residential mortgages was suspected, both in the UK and US, of not being as sold and no one was really sure who held such other sub prime assets.

    It was the market's realisation of this and lack of knowledge (about who owned the suspect assets and who had insured them) that resulted in the collapse of a bubble and the retrenchment we now see. Had Northern Rock been able to continue rolling over its short term borrowings from the open market, it could have carried on borrowing and lending at over 300% LTD without NECESSARILY moving to 400% as you claim in your Pyramid hypothesis.

    In any event, only sovereign banks can "create" money - all other banks take it as deposits or borrow from elsewhere. The difference between borrowing from elsewhere and taking deposits is that borrowing involves repayment at a defined future date, whereas deposits are at will. Please explain how a bank can lend more than it has borrowed or taken as deposit, this being the underlying assumption of your Pyramid argument.

    By the way I attended Imperial College - Civil Engineering, 1977-80 – so we are alumni of a sort.



  69. In turn I responded:

    Dear Andrew

    (I hope you do not mind to call you by first name. And, of course, I do not want to sound patronising as indeed I appreciate your feedback. Whether I agree or not does not matter as it always scrutinises and improves my blog.)

    What is a pyramid scheme? By definition, it is a system that assumes an exponential growth (with base greater than 1) to an underlying base from which the growth starts. In case of this crisis it is all about Money Multiplier (MM). When you lend with Loan to Deposit Ratio greater than 100%, MM grows exponentially to infinity. This is an objective mathematical fact. Of course if you just let it for a short period of time, it may not result in damage (although the depletion of reserves will still happen). The practical problem is that whilst you can easily calculate MM based on macro figures (loan and deposits value on the books) when Loan to Deposit Ratio is less than 100%, once you lend with Loan to Deposit Ratio greater than 100% you lose that control.

    Historically, you could have employed your argument to defend schemes that Albanian gangsters run. If they limited their ratios early Albania would not have collapsed in 1997. The problem with pyramid schemes is that they are practically uncontrollable (in computing terms: intractable). That's why they are illegal.

    It is all on my blog.

    For the Northern Rock effect, please read: http://gregpytel.blogspot.com/2010/02/comment-to-largest-heist-in-history.html

    As long as banks have cash reserves they can lend more than they take in deposits or borrow by pushing out their reserves on the market and replacing them (and still calling as reserves) with papers created, financial instruments, in this process (like collaterals). That's what really happened and caused the crisis. Banks were left with such papers and little cash, whilst cash ended up (to a massive extent) in offshore financial centres. Have you ever heard about liquidity crunch in an offshore banks? (Please note Iceland was not a proper offshore centre but a pyramid pump for offshore centres.) That's why banks "assets" turned almost overnight to toxic waste: there was no more cash going around to settle transactions (as MM became to large).

    Anyway, it is all on my blog already. Your e-mail prompts me to write a proper reference/index page as your questions have already been answered on my blog. (But it is my fault.)

    BTW, I am happy to publish your e-mail and my response on my blog (you can do it as well without subscribing to anything). If I am to do it, do you want me to publish your comments without revealing your identity? (I always respect requests for anonymity: it is merits that count. I consider my blog with a pinch of salt but as a serious quest in getting answers to the causes of the current crisis.)

    I really appreciate your time to read my blog and send the feedback.

    Best wishes


  70. ...and got the following response back from Andrew:


    No problems with publication. I think the main reason I disagree that this is a pyramid is the lack of taking deposits and paying them out to earlier depositors, while claiming that the payout is “interest”. In your worked example, the end result is that the final borrower has ALL of the cash in the system and the banks have no reserve. Now, if everyone pays their interest and capital on time, the banks will get their money back and the (net) interest they are due. There is no way for a true pyramid to achieve this, either because the early investors have taken out too much in interest or because the originators have siphoned off a large portion if the investors’ money. Your point about lending over 100% of deposits being exponential is really a red herring – excess lending stops at the end of reserves or the willingness and ability of the markets to lend; how it actually arrives at that point is irrelevant.

    The problem is that the system, in your worked example, has absolutely no ability to weather even the smallest shock (a missed interest payment or a downgrade in any of the assets in the system), because the banks only have each others promissory notes as their assets. To overcome any problem, they have to sell the promissory note (not to the other bank, because that has no cash either) to raise cash to make the payment – if all the banks in the system have behaved in the same way, there will be no cash to be had.

    I think your point about inevitability of failure, therefore, is correct, because there will always be shocks to test the system and the banks need instant access to cash to keep the commercial wheels rotating – if all they have is each others paper, because they have lent their reserves out, failure results. It’s still not a pyramid scheme.



  71. ...and I responded again:

    Dear Andrew

    You wrote:

    "Now, if everyone pays their interest and capital on time, the banks will get their money back and the (net) interest they are due."

    But the banks were pushing this money, which can be considered (once operating costs are deducted) as deposits of banks in themselves, back on the market with Loan to Deposit Ratio greater than 100% (thereby diluting reserves even further).

    Perversely if lending with Loan to Deposit Ratio greater than 100% is allowed and interest and capital are repaid it does stabilise the system but this allows a pyramid (i.e. Money Multiplier) grow even larger making the eventual collapse even more spectacular.

    Of course my example is a simplification. But as you could see now if I add to it interest payment and capital repayment, it does not make it more stable but allows it to grow bigger (until eventual collapse).

    Whether my point about lending with Loan to Deposit Ratio greater than 100% is a "red hearing" I do not care (no arrogance intended, just a fact): I simply point out that it is a mechanism of growth (very fast, exponential, growth) of Money Multiplier to infinity (if not stopped, for example, by a pyramid collapse). And it is a too huge massive Money Multiplier (sometimes called leverage: this name misses the point a bit) that it is - not disputed now - the cause of the banking crisis.

    Best wishes


  72. design of the layout perfect and i must commite this article one of the best i ever read mortgage calculator make money online komputer

  73. Hi Greg,

    I have just read your blog the contents of which I totally concur. It is apparent however from some of the comments, made on here, that most commentators do not understand the full power of the exponential function or indeed how it works. I suggest to them that they do some research on the subject and they will then be able comprehend your theses more precisely.

    Furthermore some commentators have not been able to get their head around the workings of monetary creation. They need to understand that in its process, only the principle is created, but not the interest; consequently, therefore it is necessary to keep increasing the supply of money (debt) just to cover that interest.

    I hope that this will help.


  74. Dear Greg

    You have managed to pick a very simple theory out of a very complicated situation and explain it very simply (to me anyway). This is very diffcult thing to do and a worthy achievement.

    I note the comments of detractors and I suggest that they simply reflect the gap between theory and implementation. Implementation, in this case, is an attempt to keep an unsustainable train on the rails for as long as possible and this is also what government bailouts have been attempting to do. The problem is essentially that the cycle can only be maintained if new money is being created in sufficient quantities. The money being used to sustain the process is simply one tranche of money being circulated continuously until the exponential growth of promises spreads it too thin to service those commitments. Modern money (fiat money) is simply a promisory note which functions adequately until the holders no longer think one is 'good for it'. I'd suggest that this is the reason money became detached from assets because there simply were not enough assets to go round. Assets were seen as a restriction on the circulation of money. Ergo, private institutions were, in effect, able to create new money through issuance of debt but rely on soverign issuance of money to pay for it. Is this quantitative easing? Sounds respectable ;)

    I'd guess that, at some point, money has to come back to assets in some form. Finally it may come back to ability of land to support a population, which is more or less where it started (bit of a problem for small countries with large populations). I'd further guess that, if we now exist in a global debt based economy, there must also be a formula that shows where the exponential issuance of money to service the exponential growth of debt would reach an unsustainable point? However, this is theory. The potential problem may never arise while the parallel process of production and consumption can be used to mitigate the economic problems we are creating.

    Quantitative easing (I hope) is the process of allowing the financial markets to get back in touch with the production/consumption process which could, ultimately, render the present financial debacle irrelevant. Ultimately regulatory bodies would have to ensure that the two could not become detached again.

    I doubt it would ever be possible to obtain a criminal conviction as the diversity of processes which created the actual situation are probably too complex to make it through a court of law being, more or less, within the scope of defined laws. But the basic principle you express is sound (imho), though I do think it could not have happened without the existence of fiat money, in practical terms.

    There are many pointers in post war history which help to explain how we got to this point. As a nod to our retired banker who commented - De-skilling, which occurred in the 80's is an interesting one. The process of replacing mature, experienced (and therefore costly) workers with sweet young obedient graduates. But many others, of course.

    Furthermore, it would be a little harsh to allow the free markets to determine the losers as they would, in the main, be end consumers rather than bankers. It may be a little more interesting to see an international government agreement to declare all derivatives and securitised debt null and void haha.

    Anyway Greg, excellent piece of work and excellent discussion.

  75. Dear Crackersjv

    Thanks for a very detailed and informative, excellent comment. I would add that there is no such thing as "free market". History teaches us that a completely free market becomes not free as a result of all sorts of abuses (like monopolistic) and a state attempt to prevent abuses leads to a different kind of abuses (indeed being an abuse in itself to a concept of free market). And free market always exists in a social context whether in America or Scandinavia. This, in turn, affects what free market is. Generally the term "free market" became a mantra and ideological tool of all those whose actions led to the creation of the most pathetic economic system in human history: "the communism for the rich". (However a solution to it is not a "communism for the needy";-)

    If you believe my blog merits it, please spread the link to it around.



  76. Thank you Greg

    Yes, free market came from somebody else's posted comment that I was effectively replying to. A truly free market would be the absolute recipe for meltdown, hence it is never quite allowed to be truly free. It is presently free enough to suit certain vested interests, which is why we can be talking regulation.

    The other thing I should have mentioned and didn't, is use of the word inflation. Inflation used to relate to the growth of the amount of money floating in the economy, usually beyond underlying asset values. It subsequently became price inflation, which is a completely different thing. However, we have now buried 'inflation' within a number of different terminologies or measures which few people pay much attention to. If we were citing it in the current environment we would be talking about something way beyond hyper-inflation - Fiat money and quantitative easing :O

  77. Thanks. I agree, although I sense that I may have slightly more laissez fair view than you have. But this is beyond the point. The current crisis, in my view, has nothing to do with any ideology or approach to socio-economic system (e.g. laissez fair v socialism). It is a result of pretty crude criminal activities, exactly the same in mechanism as Albanian pyramid crisis in 1996 - 1997. This should unite taxpayers regardless whether being from left or right.



  78. Great blog, Greg. Only just discovered it.

    I was wondering one thing though - similar to some of the comments above.

    You say above...
    'UK banks loan-deposit ratio was 137%. In other words the banks were lending out on average £137.00 for every £100 paid in as a deposit.'
    .. and then gave some per-bank numbers (so Northern Rock 300% +)

    I was wondering how these numbers are calculated and what they really mean ? In NRs case - surely it couldn't be the case that every time someone deposited £1, they lent out £3+ ?

    As you say this would tend to infinity very quickly (by a cube law in this case) and although they were bad, were they that bad ?

    Are there any other regulations that act as a brake - such as minimal reserve requirements ? If they were doing as you say, I'd expect them to have close to 0% reserve.

    You've explained very well how the theory of breaking the fractional reserve limits could lead to a highly dangerous situation - I'm wondering what the per-bank figures really mean in practice. Would a 'reserve ratio' figure be a better measure of a bank's behaviour, or is that flawed in some way ?

    best regards,


  79. Matt

    thanks for reading my blog (if you think it's worth it, please spread the link to it around).

    The answers to your questions are already on my blog. Please check up:

    About loan to deposit ratio in detail:



    About the nature of banking reserves:


    About regulations (preventing the crisis in the first place):


    I hope these articles answer all the questions you raised. If not, please come back to me.

    Best wishes


  80. Greg,

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

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

    Cash: $104.91
    Loans: 0
    Deposits: 0

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

    Cash: $104.91+$100 = $204.91
    Loans: 0
    Deposits: $100

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

  81. Hi VJK

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

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

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

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



  82. Hi Greg,

    you say that without treating securities as as-good-as-cash banks would not have been able to surpass a LTD ratio of 99%. Steve Keen the economist states that banks create credit and then look for reserves after. Are you aware of his work and are you talking about different processes?

  83. Hi Richard I say that without treating securities as as-good-as-cash banks would not have been able to surpass a LTD ratio of 100%. With LTD, say, 99.999999% you can also destroy the banking system as the money multiplier would have been 100,000,000, but the dynamics of the process would not have a pyramid run-away characteristics. Anyway it would have been a distaster. My point is that you can destroy the financial system in many ways without LTD greater than 100%. However with LTD > 100% it is a straightforward criminal pyramid activity akin to Albania in 1996 - 1997.

    Thanks for pointing me to Steve Keen. I will check that up.

  84. Several of your previous commentators seem not to believe that banks can actually create money and thus lend more than they have on deposit.

    I have assembled many credible quotes on the topic of banks creating money - unfortunatly your blog's comment section won't show even a quarter of them because it only allows 4k characters maximum.

    So:- if you are interested - please read the article at :-http://steelydanswarandpeace.blogspot.com/2009/03/fiat-money-and-quantative-easing.html

    It explains Fiat money, Quantative Easing, Fractional Reserve Banking etc.

    Incidentally - my whole article needs re-writing - Mr Pytel you'd be just the man to do the job!

    Be well

  85. Hi Dan

    Thanks for your comment. To "combat" 4k characters limit, please split your comments into multiple posts. (I did it myself in the past.) Comments on the merit will never be considered as spam (even if I do not agree with them).

    All the best


  86. You may find this of interest http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html Quote:

    What is the engineering mistake that caused the financial system to be so sensitive to this relatively minor piece of graft?

    The engineering mistake is an accounting practice called maturity transformation. In the best CS tradition - I consider it harmful.

    Maturity transformation might also be called monetary time travel. It is an accounting structure which permits a financial institution to pretend that it can teleport dinero from the future into the present. High-tech modern finance can do many cool things, but this is not one of them.

    The price we pay for this illusion is a fundamental instability in the lending market. To most economists, this instability is a Diamond-Dybvig dual equilibrium. To Austrian economists, it's the Misesian theory of the business cycle. And in plain English, it's your common or garden bank run.

  87. "In order to answer these questions we have to examine the basic principles on which the banking system operates and the mechanisms that caused the current crisis. Students at the A-level are taught about “multiple deposit creation,” It is the most rudimentary money creation mechanism for banks, which if administered properly serves the economy and public at-large very well."

    This assumes that the money supply is exogenous.
    A more realistic assumption is that money supply is endogenous?
    "In fact, as we were made well aware by the vast bubble of credit/debt created by the private banks – there is no relation between ‘capital’ in the bank and lending. The money for a loan does not exist, until a borrower applies for it. And contrary to widespread belief – loans create deposits.
    In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.”
    Does this affect your analysis?

  88. This is a very attractive segment, gave me a lot of help, thank you for sharing, hope you can update more and better stories.Round Rock Condo

  89. Your philosophy of life led me to a whole new world that broadened my horizon.Lago Vista Real Estate

  90. Greg - I would love to read your thoughts on our private pension system. Apologists for the UK finance industry say that it is the best in the world and that the enormous salaries and bonuses paid ensure that the best talent stays in this country.
    If this is true, why is my private pension worth so little? I have been paying regularly into a private pension fund with a "blue chip" company for more than 20 years now. My latest pension statement shows it will give me a pension of slightly less than £2000 a year when I retire. If I had invested the money in a post office account over the last 20 years it would be worth more.
    Thankfully I ignored all sensible advice a few years ago and bought a second flat, which I am renting out. By the time I retire, the mortgage should be paid off. If anyone is wondering why the British use property as an investment, this is why - you'd simply be mad not to, given the alternatives. So much for our wonderful financial industry.

  91. Dear Natalie,

    thank you for reading my blog. If you like it please pass the link to it around. Answering the issues in your comment:

    1. In my view the government should take liabilities of private pension schemes on their books. Maybe introduce a top cap in this offer (this to be a matter of public debate so I do not suggest any figure) or some haircut for pensioners (only for pensions above certain threshold and a reasonable one like 15% - 20%) or some combination. This would be much cheaper for the taxpayers than subsidising the entire financial system (including all overheads, huge salaries, bonuses, etc) as the government is doing now. This still does not stop the deterioration of the value of private pension schemes but it is bringing the entire economy into ever deeper debt (effectively bankrupting it). I suggested this approach in the article above over 3 years ago (i.e. I wrote above: "In a normal free market economy a business that fails should be allowed to collapse. If a business is a giant pyramid scheme, like the current financial system, it must be allowed to collapse and its executives and operators should face prosecution. After all running pyramid schemes is illegal. Letting the banks collapse would have been a far more commercially sound solution than the current approach, provided the governments would have secured and guaranteed socially vital interests directly. For example, individual deposits would be guaranteed if a bank collapsed. Deposit accounts records, along with mortgage and genuine business accounts, would be moved to a specially created agency of the Bank of England which would honour them with government help. If a pension fund collapsed due to a bank collapse, individual pensioners would continue receiving their unchanged pensions from the social security system. This would guarantee social stability and a normal flow of cash into the economy.") If the government had taken this option there would have been no financial crisis and a lot money and jobs would have been saved. But the losers would have been the bankers and top financiers. So I am sure you understand why the government is not going to listen to such suggestions.

    2. Regarding "top talent" in the financial industry. This is a really idiotic and scandalous myth that exists. But as it is so obvious, people who believe in it have to be considered at least as intellectually retarded. Please read another article on my blog where I considered this issue in detail: "Curbing City pay will give it competitive advantage": http://gregpytel.blogspot.com/2009/08/curbing-city-pay-will-improve-its.html



  92. I've read several excellent stuff here. Certainly worth bookmarking for revisiting. I surprise how so much effort you place to create this sort of magnificent informative website.
    Little Tikes Table and Chairs Set

  93. This blog is very helpful for all student who read online. And want Homework Help Service.Thanks for you all students help. And keep continue to helpful post.

  94. Hallo Greg

    Many thanks for this information as well your replies to the comments given. For us non-financial people muddling our way though this, it is a true eye opener and clarifies our suspicions.
    One item that is of great concern to me (as well as many people i know) is that the system is still functioning as was and no one has been held accountable. We read and hear continuously on fraud, LIBOR etc but somehow we seem to standing in the same place as we where in 2008??

  95. Many thanks for the wonderful article.

    1. Thanks Mario for a nice word:-)


  96. Thanks for sharing such an informative post. In this type of shaky economy that we are in, having an income protection plan beforehand is a smart move but other than that, being able to spend and invest wisely is indeed a wise thing to do.

  97. Geoff Toase 14 November 2013 15:23

    Greg really informative post. A suggestion from 'Birthright Denied Future Stolen' Economic power is the central component of the capitalist system – government’s total subordination of national financial systems to private finance has handed wealthy individuals and organizations an overweening power. It includes the delivery of resources, food, shelter, infrastructure, jobs, and income – the competition for the public’s money is between a small number of huge finance houses (the big 5) who, in the UK are guaranteed a slice of £50 Billion per month (they can make use of about £15Billion) paid out in wages and salaries because of the almost total move away from the physical transfer of cash, which a worker could dispose of at their own discretion, to electronic transfer the access to which a private bank controls. It is free to remove those deposits from the national economy as it sees fit; the depositors do not have the choice of supporting their own economy by placing their savings, salaries or wages in a national bank (supported, but not run by the State) that cannot invest outside the common domain – real competition for the public’s money for the private sector.