Banking Crisis - Treasury Contents

Memorandum from Greg Pytel


Building the Great Pyramid: The Global Financial Crisis Explained

  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?


  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 five 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.


  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 five 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.]


  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.


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

  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 £40 billion. 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.

Table A


Lloyds TSB140.84%8.1%
Alliance & Leicester172.41% 3.6%
Bradford & Bingley172.41% 3.9%
Northern Rock322.58% 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—]

    —  Abbey position after acquisition of Bradford & Bingley was 75%




Table B

  [source: MS Research/Howard Davies Presentation—]
France + Benelux103%
UK + Asia89%
February 2009

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