BANKS AND LEGALIZED PONZI SCHEME

Last week, I saw a documentary on TV about the acts of one famous person – Bernard L Madoff. Sounds familiar? Well, he is none other than a person who has made headlines in the US in 2008 – where he has made off with USD50 Billion of other people’s money...just like that, whoosh...money gone.

Madoff confessed that all these years he had been running a Ponzi scheme and, in fact, never made any significant money by investing.

What is a Ponzi scheme?

A Ponzi scheme is a fraudulent investment system where the investment house eats up the investors’ money, but gives them the impression that their money is producing good returns.

This is accomplished by paying dividends to earlier investors using the money coming from later investors rather than from profit. Any incidental withdrawals are also managed the same way. The system works if the amount of new money coming in is more than that required to pay these returns and withdrawals and to cover operating expenses. The scheme however fails if too many investors want to withdraw their money or enough new investors are not coming in. Both of these events are likely to happen in an economic downturn.

This is exactly what happened to Madoff’s Ponzi scheme and its disastrous results are now well known.

Banks and legalized Ponzi system

Come to think of it, one has to admit that banks are, in effect, also a legalized Ponzi scheme and therefore are also subject to the same pressures.

Banks in the US are allowed to leverage themselves up to almost 50 times their total assets, which means that when fully leveraged, a 2% loss will wipe out their assets. The bank will have therefore eaten up the investor’s money. Because 2% losses in business are common place, this asset wipe out is not an unlikely phenomenon. Under these circumstances, what keeps the bank operational and appearing healthy is the money coming in from new deposits. These new deposits are used to pay operating expenses, to service withdrawals and to pay any dividends that become due. Just as in a Ponzi scheme, if the new deposits fall below a critical level, the whole banking system will come crashing down.

This appears to have been the case in the United States at the end of 2008. This will destroy confidence in the system for a long time to come and therefore will damage the economy severely. The banks therefore needed to be supported by large infusions of cash making up for the missing new deposits that did not come in because of the economic downturn. This support will need to continue until the economy recovers to a point that the new deposits exceed the amount needed to service withdrawals, dividends and running expenses.