Memorandum from Greg Pytel
Building the Great Pyramid: The Global Financial
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 isor wasa very active interbank
lending. In terms of deposit creation the system works like one
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 trickthe
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 downa 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
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 £100not
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 bonusesnot 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
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 systemso-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 customerstheir
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
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
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 actionincluding
the recovery cash and assetsmust 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
"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.
|Alliance & Leicester||172.41%
|Bradford & Bingley||172.41%
|Weighted average LOAN/DEPOSIT RATIO = 174.26%
the RBS position includes ABN AMROwithout
it RBS position was around 135% [source: MS Research/Howard Davies
Abbey position after acquisition of Bradford &
Bingley was 75%
[source: MS Research/Howard Davies Presentationhttp://www.lse.ac.uk/collections/meetthedirector/pdf/Banking%20and%20the%20State%2002.10.08.pdf]
|France + Benelux||103%
|UK + Asia||89%|
| February 2009 ||