Capital Risk Weightings for Crash Test Dummies

Illustration to ring-a-ring-a-roses in Kate Greenaway’s Mother Goose, taken from the Project Gutenberg version project gutenberg: www.gutenberg.org/wiki/Main_Page in the public domain.


Children cling to their blankies and you cannot part them with the Disney printed fluffy blanket even when dirt, food and unspeakable things disguise Eeyore’s picture for all but the tail. Sometimes I think economists have a blanky relationship with reserve and fractional banking.

The fact is reserve banking hardly features in debt formation decisions. It was fundamentally and decisively replaced with a system of Capital Risk Weightings as introduced in Basel I and refined in Basel II. The Bank for International Settlements is very aware of risk in international settlements and the name of the money game has always been to receive settlement (or to get it back if you’ve lent it out). Capital Risk Weightings is a magnificent distributor of debt yet when you mention Basel II or Capital Risk Weightings, economists seems to prefer the blanky. The reality is that reserve requirements are so easy to meet, banks run out of capital long before they have problems with reserve requirements.

It can get complicated but let’s discover the basics of Capital Risk Weightings through Sarel’s Bucket-shop Bank Inc (SBBI for all your Debt needs).

I convince family and friends to hand over their savings say $100,000 and I issue ordinary shares of $1 to each of them (100,000 shares in total). Time to go shopping.

Office Furniture $30,000
Computer Equipment $60,000
Office equipment and Counters $20,000
Stocks of Consumables $10,000

Oops, I spent too much. No problem, I’ll just borrow $20,000 and I’m ready for business.

Here then is the Balance Sheet of:

Sarel’s Bucket-shop Bank Inc





Having only tier 1 capital is totally inefficient. I can get some tier 2 capital by issuing long term bonds (normally 5 years or longer) and I need an equal amount of tier 2 capital. So let’s go ahead and issue long term bonds for $100,000.

Now I need some Central Government Bonds and treasuries to manage my liquidity access so I buy $100,000’s worth of Government Bonds, which thankfully has a Capital Risk Weighting of 0% and have no impact on my qualifying capital. You noticed off cause that we could run an infinite Ring a Ring o’ Roses here borrowing from the Central Bank and lending to the Central Government with absolutely no limitations other than that dictated by the Central Bank. Until we all fall down, that is.

My new dressed up and ready to go Balance Sheet looks as follows:


Sarel’s Bucket-shop Bank Inc



We are now in the banking business. First question, how much can I lend out (we’ll worry about the liquidity a little later)? The Basel II Concordat would generally require a 4% tier 1 primary share capital requirement against the Capital Risk Weighting. (Allocations of Capital Risk Weightings may differ for different countries and split at 8% primary capital and 4% secondary for up to 12% total capital allocations but the calculation method will remain the same.) The tier 2/3 requirements can range from another 4% to 8% but let’s just work with 4% tier 1 and 4% tier 2.

Here is the Capital Risk Weightings table.


Data Source: Bank of International Settlements.

One more risk weighting which is important, Qualifying Residential Mortgage Bonds at 35%.

Now to answer the question, “How much can we lend out?” The math is not complicated.

1. AAA to AA : No limit - as much as we can get in liquidity.

2. A+ to A- : Step one is to calculate the capital co-efficient, easy 8% times 20% and it is equal to 1,6% (0.08*0.20). We have $200,000 in qualifying Capital so we just need to divide $200,000 by 1.6% to tell us that we can lend out = $12,500,000-00. That is a tidy sum of money. Let’s check the calculation. We need to hold 1.6% in qualifying capital against out lending activity. Thus $12,500,000-00 times 1.6% is equal to $200,000 and we’re all filled up with lending. Say we can lend out the money at 4% and get deposits at 2.5%; then we can make 1.5% gross profit on $12,500,000-00. That will give us $187,500-00 pa in gross profit for a Gross Return on Shareholders Capital of 187,5% ($187,500/$100,000).

3. The next best capital allocation lending to engage in would be Qualifying Residential Property. Here goes: 0.08*0.35 = 0.028 (2.8%). Now $200,000 divided by 0.028 = $7,142,857-14. We need to get a better profit margin than A+ to A- lending so let’s say we get deposits at 2.5% and do mortgage lending at 5.5%. That’s a 3% Gross profit margin for a gross profit of $214,285-71 (7,142,857-14*0.03) and Gross Return on Shareholder’s Capital of 214.29%. We can obviously now calculate at which level of lending rate we will prefer A+ to A- lending above Mortgage lending.

There is no need to continue the math as the principles have been demonstrated. Let’s say we’ve decided to concentrate on Mortgage Lending. We convince depositors to give us the $7,142,857-14 and we pay 2,5% interest pa. They have deposit insurance, no risk and should not have any problem to give us the money (not so?).

Our impromptu bank is a good little business at this stage.


Sarel’s Bucket-shop Bank Inc




We are certainly not maximising our efficient use of capital. Thus the next business decision is to do an Asset Backed Securitisation. We take $5,000,000 of mortgages, securitise them and sell them off to investors for an immediate $400,000 trading profit. Fantastic, we now have an additional $400,000 in tier 1 capital and we have also released precious capital held against $5mil mortgage bonds. Time to maximise business activity by lending everything we can to build a much bigger Residential Mortgage portfolio.

Say we use the $400,000 to buy Government Bonds again. We must issue another $400,000 to get tier 2 Capital, again we buy Government Bonds with it. I’ve done all the calculations and our bank now looks like this:


Sarel’s Bucket-shop Bank Inc



Can this be for real, you may ask? Certainly, it was exactly how the game was played for every turn of the asset cycle from portfolio, to securitisation, to sell off produced immediate executive bonuses and the tills were ringing, ka-ching.

We are now a bank with $36.7mil in assets and doing very well. Unfortunately we get a Global Financial Crisis. Liquidity is not a problem (access to liquidity is so easy we do not have to overly concern ourselves with any reserving requirements that the Central Bank may impose on us). We just securitise the $35.7mil Qualifying Mortgages and do repurchase agreements with the Central Bank. The real problems are:

1. We can no longer get deposits to grow.

2. We get bad debts exceeding our gross margin of 3%.

3. We basically have only $500,000 of capital for a 1.4% capital protection against the $35.7mil mortgage loans. In banking talk, we cannot survive more than 4.4% bad debts on a Gross basis (3%%+1.4% and it is a lot less on a net basis – we have to live and get our bonuses).

4. What are we going to do when house prices drop by 50% and “home owners” hand in their keys? Half of the 35.7mil is $17.9 mil against only $500,000 in capital. We have a serious collateral problem not only on our books but also in all the securitisations that we have sold off.

5. We are actually impossibly beyond redemption.


Sadly here is where Sarel’s Bucket-shop Bank Inc kicks the bucket (RIP).

I hope that this simplified essay on Basel II based debt allocation will convince more economists to study the Basel Accords for applied modern banking practices and the interaction with Central Banks. Combine Capital Risk Weightings, easy access to liquidity, deposit insurance (explicit or implied) and securitisation for a turbo charged debt distribution channel far superior to any text book description of fractional banking and reserve requirements.

The role of Central Banks in facilitating unlimited liquidity provision to the banking sector has permanently changed the banking landscape into debt driven activity with deposit taking having been relegated to an afterthought. The fixation of deposit driven banking theories simply no longer apply and it is time to retire the blanky.



Sarel Oberholster
BCom (Cum Laude) CAIB(SA)
14 February 2009

© Sarel Oberholster

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Fractional Banking is a Mirage

Some economists call for 100% reserve requirements of demand deposits. Reserving requirements and the money multiplier are often discussed at the same time.

The economic theory in support of increased reserving requirements and fractional banking is the theory of banks as creators of money.

The essence of this theory holds that:-

1. bank credit is accepted as money, and
2. customer deposits can be leveraged to create money.

Perhaps one should differentiate between “bank deposits” and “customer deposits”. The premise is that a bank can give a debtor a credit limit and the debtor can utilise the “credit” as if it is money.

The theory is normally simplified in the Monopoly bank with a 20% reserve requirement as follows:-





The model is static so a new deposit originating outside the construct must be introduced to facilitate the money creation process. This external source could be the activity of a Central Bank but is simply defined as an external source. The absence of a defined source allows the model to be built on fiction and is a logical quickstep required to make this theory work.

Introducing 100 units of deposit from an external source would allow the Monopoly Bank to use the new deposit for reserving requirements and “create” credit for 400 units. The new Balance sheet would be as follows:-





The 20% reserve requirement can be tested at 1500 x 0.2 = 300 units and the model is stable again.

This theory is generally taught as true but with criticism. It is actually fatally flawed and incorrect. The fatally flawed components are disguised in the undefined external source. Even more relevant is the time between the introduction of the External Deposit and the re-balancing of the Monopoly Bank’s balance sheet. The most important omission is that a production channel is accessed in this period.

The Source of all Deposits

There are two sources of deposits:

1. Savings which originates form a production surplus. Such “Savings” are available for a specific time period which can be for an hour, a day, a week a month, ten years or any such period in accordance with the specific needs of the Saver. Thus a person receiving wages on Friday afternoon may allocate his or her wage income over the next 7 days towards consumption yet a portion will enter the pool of savings and an ever diminishing portion will be available as “Savings” for the next 7 days. Note that the wage was earned in the production process. The “Savings” is 100% supported through production.
2. Unfunded monetary credits originating from “an external source”. Unfunded monetary credits are not “backed” by a production input to the economy and as such are imposters pretending to be savings.

Testing the Fractional Banking Model against the origin of deposits.

The receipt of the 100 units of External Deposit by the Central bank as a reserve requirement may have been sterilised at the Central Bank. Let’s make it so for the sake of simplicity but it is not a prerequisite requirement. Monopoly Bank granted credits of 400 units but such credits did not simply go from the recipient of the credit straight back to the Monopoly bank. No, the recipients used the credits for a purpose, to pay taxes (government spending), to buy consumables (consumer spending) or for investment (investment spending).

The 400 units of money entered the economy and the recipients received economic value for the credits. Economic value in the form of production value. Let’s proceed with a short cycle and state that the producers deposit the proceeds with Monopoly Bank.

The fact is that the 400 new units of deposit originating from the bank credits are backed by a production process. This is an absolute truth. To borrow on one hand and re-deposit on the other would only be possible under arbitrage conditions and can never fulfil any role in general economic theory. The application of the 400 units will cause malinvestment and misallocation of resources as it was made possible by a supply of unfunded monetary credit. The external origin of unfunded monetary credits is the malaise, not the banking sector when it performs its functions as expected.

It is therefore not valid or true to claim that the Monopoly Bank had created money. The Monopoly Bank did anticipate the receipt of savings backed by a production process. How was this possible? Again the model is silent. It could only happen if the Monopoly Bank could obtain a “loan” from an external source to fund the process until such time as the 400 units returned from the production process. Such a loan could have no other nature than that of an unfunded monetary credit.

Interventionism
The fractional banking model is incorrect and economically dishonest by omission. It requires two very specific monetary interventions to facilitate debt formation. A pre-existing much more menacing intervention is reserving.

Economists seldom realise that the very act of reserving is a severe intervention. It acts against the interests of the very economic participants it pretends to favour, the Saver. Any form of reserving requires that a portion of legitimate Savings must be removed from the economy, logic enmeshed in true Keynesian tradition. Savings sterilised is the only Savings not available to the economy in the normal course and robs the Saver of potential rent.

The interventions in the relationship between the Borrower and the Bank should receive the criticism of the libertarian economist. Similarly should the interventions in the relationship between the Saver and the Bank be criticised. Proposals to sterilise the Savings in the economy through reserving should not be confused with sterilisation of money creation from nothing. The one is a result of a production process in the economy, the other comes from nothing.

A 100% reserving requirement would entirely remove any rent that the Saver could earn, limit available savings and severely damage the economy.

The problem of money creation must be addressed at the intervention where it happens and not be exacerbated by punishing the Saver, the Bank, the Borrower and the economy. Each of these entities is a legitimate participant to the market and entitled to pursue its own best interests in true libertarian fashion.

The collection of short term savings in demand accounts is still legitimate savings. A discretionary subjective judgement regarding “demand deposits” should not take the place of a functional intent, that is, the bank must at all times comply with such demands of fail as a bank. Such is the nature of free market economics.

It is a fundamental function of banks to manage the pool of all deposits to achieve a transformation of funding time preferences inherent to the management of a dynamic deposit pool. Any deposit pool will have a predictable and stable component which can be utilised across the yield curve to provide much needed term funding. A 100% reserving requirement would destroy this market function of banks, invite the inevitable intervention spiral, impose an economic cost on unsuspecting economic participants, distort the much maligned savings market even further and starve the economy of the largest pool of savings available.

The interventionism of reserve requirements is similar to all other interventions and will generate the usual outcome of unintended consequences.


2 February 2009

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Economic Highway to Hell

“The road to hell is paved with good intentions” - proverb
(Generally attributed as a derivative originating from Saint Bernard of Clairvaux; 1090-1153).

There is an underlying philosophy in law which holds that it is better (but obviously not ideal) to let the guilty go free rather than to imprison or execute one innocent person. Perhaps this is a derivative of a religious principle which proclaims; “Do no harm”.

It is very easy to spin Government and Central Bank interventions as “doing good” and in the national or even international interest. How important these modern day political saints must feel. Unfortunately there is an inevitably dark side to their doing good. They often cause as much harm and more often than not, more harm than good because they are always goal orientated, justifying any harm by the good that they are supposedly doing. The very best way politically to present these “do good” interventions is to present them as absolutely vital and without any alternative.

It is long overdue to judge these interventionist actions by a standard of “Do no harm” as the “do good” requirement is just too easy an objective to achieve by itself and open to scandalous abuse.

The economic highway to hell is paved with good intentions in the “national interest”. Everybody has tendered their 2009 lists. Here is my 2009 list of byways feeding into the economic highway to hell, in no particular order of priority.


1. Monetary stimulations

Monetary stimulations must originate from the realm of economic psychopaths. It pretends to be a stimulation but in fact is a redistribution of monetary value away from existing holders of money towards recipients of the monetary stimulation. Thus it is at best neutral and at worst an inefficient and often corrupt bureaucratic reallocation of scarce resources. The transfer of monetary value in the process of monetary intervention is entirely without conscience. The redistribution is most telling in taking away from those unable to raise credit and gifting to those most able to raise credit. Is it really necessary to underscore the hypocrisy of redistributing away from the unsophisticated, the poor and the pensioner, for who are the members of society to whom access to credit is restricted? What hardship hides behind the contorted and convoluted explanations to justify the monetary redistributions as in the national interest?

Monetary “stimulation” fails the test of “do no harm”.


2. Interest rate targeting

The price of almost every economic good or service is influenced by interest rates in a global economy immersed in debt. Control over interest rates is economy wide price control by stealth. The distortion in the price for the use of savings is an evil of the first order and the malinvestment from the structural distortions of interest rate manipulation, an evil of the second order. Every price distortion extracts for one and subsidises another. Can Politicians and Central Bankers tell us that this monetary intervention will impact that price or are these interventions but arrows fired into the darkness of ignorance? Have they got a tally of the harm that may be done and do they care?

Interest rate targeting fails the test of “do no harm”.


3. Fiscal Stimulations

Where are the savings of a government? Have they got some secret “treasury” with treasures of savings? No? How then can government stimulate the economy?

There are two ways in which they claim they can stimulate, reduce taxes or increase spending. Both these suggestions are false with reference to stimulation as the net result in both cases is neutral. More taxes or fewer taxes does not make the economy bigger or smaller, it simply makes the share of the Government extraction from the economy bigger or smaller. Less or more Government spending similarly only says who is doing the spending but the economy is not more as a result of Governments doing the spending.

Current fashion is to do both, less taxation and more spending. It can only be achieved by increasing debt in the absence of government savings. Increasing debt is an action of discounting the future for living it up today. Governments living la Vida loca. More today, less tomorrow and all yesterdays have arrived with the advent of the global economic crisis. Government debt has become the ultimate multi generational debt where our children will pay for our excess.

Fiscal “stimulation” fails the test of “do no harm”.


4. Concentration of power

It is from the legislative frameworks of Governments that power to concentrate is facilitated. The “too large to fail” institution can without exception be traced to a co-operative structure with government. Finance and debt institutions have been welded to the interests of governments with the binding force of a fiat money system. The presence of institutions such as lenders in last resort and deposit insurance has built a gigantic financial economy dwarfing everything else. Oligopoly formation in banking is a natural consequence of the activities of a Central Bank. It’s so much easier to control and focus the actions of a few big players than thousands of small operations. Concentrated debt formation with unlimited liquidity will yeast its way into every strand of the economy and facilitate power concentration until the “too large to fail institution” is born.

Yet again has history proved that power corrupts and concentrated power corrupts absolutely.

Concentration of power fails the test of “do no harm”.


5. Bailouts

Interventionism creates untenable distortions in the market economy. These distortions are built layer upon layer over long periods of time. An intervention spiral is built upon the structural instability of previous interventions until extreme interventions such as “bailouts” and indiscriminate nationalisation of “too large to fail” industries can be presented as “doing good”.

Bailouts do absolutely nothing to solve the problems of structural distortions; in fact bailouts are a last gasp end game strategy at trying to maintain the structural distortions. Today’s bailouts will become tomorrow’s nationalisations. Bailouts have no economic healing power and are imposters to “doing good”. Petrifying structural defects is a plague to the economy.

Bailouts fail the test of “do no harm”.


6. Government debt as reserve assets

Discover the national reserves at the Central Bank in a search for a treasury. Is it a room full of treasure? The nation’s reserves are the debts of other nations. Will they pay on demand, how and in what currency? Go from reserve to reserve; it’s an endless cycle of another nation’s debt. A huge pyramid structure of Government debt upon Government debt; funding each other’s debt in an ever growing pile of promises.

Are these benign promises? No, it’s the promise of my government and your government to extract our savings, our capital, the fruits of our labour and even the fruits of the labour of our children to pay the debt if ever they are called upon to make good on those promises. Government debt as reserve assets has given a whole new meaning to Central Banks being the banker of government (s).

Government debt as reserve assets fails the test of “do no harm”.


7. Defender of Depositors

The ultimate defence of central banking is always the role of Defender of the Depositor. The usual argument is that the individual depositor is too ignorant, too unsophisticated, unable to afford the research, too uninformed and generally unable to distinguish between a solvent or insolvent bank.

In steps the Central bank as the Defender of the Depositor to regulate the banking sector; to manage liquidity to the banking sector; to build depositor protections such as deposit insurance, reserve requirements, capital requirements for risk taking; oversight to gather the elusive information; and often it sells itself as the protector of the weak, the widow and the pensioner. How bizarre the marriage of Protector of the Depositor and Redistributor of Monetary Wealth through the creation of money from nothing.

Who advised depositors not to withdraw their money when banks were failing? Who denied that banks had solvency problems? The very same entity which has assumed the mantle of the Protector of the Depositor. Did they not know the insolvent state of the bank and proved themselves incompetent as informed advisor to the depositor or did the Defender of the Depositor deliberately lie to the very depositors they proclaim to be protecting?

The Central Bank as Defender of Depositors fails the test of “do no harm”.


8. Abdication of responsibility

Transfer the burden of debt decision making to me, the Government says and we will protect you. It is a huge promise in which Government often fails. The Siamese twins of Treasury and Central Banks have become inseparable, sharing the same brain. It has become a daily refrain of politicians to encourage debt formation. The banks must lend. Credit must flow freely. Credit markets must come unstuck. Interest rates are at zero (by implication, you must go out and borrow and spend). The interest of the individual economic decision maker and the interests of the Central Government are seldom in harmony. Who will repay my debt and who will repay the debt of Central Government? It is but me.

Abdication of responsibility fails the test of “do no harm”.


9. Permanent Government debt

Much has been said about Government debt in this essay. Yet it is still not enough. Government debt has grown out of proportion to economic activity. More important, Government debt has assumed a permanency as never before. Is there any detectable intent from Central Government to reduce its debt? Will a budget surplus be generated and debt repaid? The very mention of a fiscal budget surplus would elicit a steam of abuse in these trying times. Government debt has assumed a permanent character, never to be repaid. How then will the creditors of Central Government ever get their money back? What if those creditors are another nation?

Your government’s debt is the inheritance that you leave behind for your children, whether you encouraged the debt, incurred the debt or benefited from the debt is irrelevant. All debts are settled eventually. The present “permanence” of Government debt is an economic abhorrence and an intolerable structural distortion. Do you leave debt enslavement as a gift to your children or your nation?

Add unfunded pension deficits to permanent Government debt and everybody will become wards of the state.

Permanent Government debt fails the test of “do no harm”.


10. Weak currency policy

It is the “exporting subsidised labour” policy. It gives work to the subsidised group of people and, as expected, at the expense of another group. Nations often get into diplomatic spats about these policies but the weak currency is just another form of protectionist trade policy. Let the nation who has not a single protectionist trade policy item in place please stand up. The weak currency policy is particularly damaging as it contributes to debt formation in many ways. The obvious first step is international trade credit and the very next step is an accumulation of government debt of the largest trade partners. Thus the practitioner of a weak currency policy would make debt slaves of the importer nations’ citizens with the consent of their governments.

Weak currency policy fails the test of “do no harm”.


Here ends my 2009 list of economic byways. I do not wish them upon any of my fellow men on women. I am unable to deceive myself into believing that mysterious sources of wealth will fund bailouts, handouts, increased Government expenditure and tax reductions. All these policies are panic, debt driven reactions to an economic avalanche of excessive debt. These policies are guaranteed to perpetuate and worsen today’s global economic crisis.

“There then arose against Bernard unjust reproaches and he was denounced even in Rome, as a monk who meddled with matters that did not concern him. Cardinal Harmeric, on behalf of the pope, wrote Bernard a sharp letter of remonstrance. "It is not fitting" he said "that noisy and troublesome frogs should come out of their marshes to trouble the Holy See and the cardinals". Bernard answered the letter by saying that, if he had assisted at the council, it was because he had been dragged to it, as it were, by force. "Now illustrious Harmeric", he added, "if you so wished, who would have been more capable of freeing me from the necessity of assisting at the council than yourself? Forbid those noisy troublesome frogs to come out of their holes, to leave their marshes . . . Then your friend will no longer be exposed to the accusations of pride and presumption". “ [my bold] http://en.wikisource.org/wiki/Catholic_Encyclopedia_(1913)

It is fitting that noisy and troublesome frogs should emerge from their marshes and proclaim the harm of these policies pretending to “do good”. Are Central Government bureaucrats and Central Bank officials not the modern day Holy See and Cardinals?

This is an era in which Government’s lust for your savings is excessive. Government has no treasury, no secret stash from which it can stimulate or bailout. Government needs the savings that you have and even what you may produce in the future. Never before has a global economy been so hungry for savings and so unprepared to pay for it. Make sure you pick the stores of value for your savings with great care lest you lose the liberty.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
29 January 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

War on Savings

Pre-publication versions are now available for download of War on Savings (International Edition) and PowerPoint Presentations War on Savings Part 1 and Part 2.

The PowerPoint presentations have been designed to simplify technical components of War on Savings – Modern Monetary Policy Deficiencies Exposed. (International Edition). Additional PowerPoint Presentations will be published in the future.

Your comments to ccpt@iafrica.com will be welcome.

Sarel Oberholster
14 January 2009

Melamine in my Money

“Melamine is sometimes illegally added to food products in order to increase the apparent protein content. Standard tests such as the Kjeldahl and Dumas tests estimate protein levels by measuring the nitrogen content, so they can be misled by adding nitrogen-rich compounds such as melamine.” - Wikipedia on Melamine

Unscrupulous operators added Melamine to pet food and the result was the death of thousands of loved pets all over the world. It should have been a dire warning but no, not long after, other unscrupulous operators added Melamine to milk products and human babies started dying. This irresistible temptation lies in the fact that Melamine fools the protein test, which in turn allows the operator to degrade the product for greater profit. The doctored foods pretend to have great nutritional value but ironically will kill you.

The horrible truth is that Melamine, a deadly toxic compound, is added to foods to cover up another criminal act. First a food is diluted to increase mass and therefore allows the operator a greater profit. Then Melamine is added to fix the protein content so the product will pass the protein tests. It is a stealth poison. It accumulates mostly in the kidneys and acute kidney failure occurs only after the body has absorbed a relatively high dose over time.

In a world of monetary management we find a similar process. The first step is for Central Banks to dilute the wealth of all holders of money by creating fictitious money. The fictitious money is fed into the economy via the debt channel. Banks are given access to Central Bank Melamine Money on repurchase agreements of Government Bonds (or any other qualifying financial assets – all forms of debt). You may immediately ask, what can possibly be wrong with that?

The repurchase arrangement between banks and the Central Banks is fatally flawed as a fictitious money creation mechanism. It is not technically difficult to understand. The bank will sell Government Securities to the Central Bank and will undertake to buy the Government Securities back after a specified elapse of time. The repurchase price would be calculated as an amount equal to the selling price plus interest calculated for the period. It is simply a loan against security but for the fact that the Central Bank becomes the legal owner of the Government Security until the Bank repurchase that Government Security. Being a legal owner allows the Central Bank to simply keep the Government Security should the bank fail to repurchase the Government Security and the Central Bank would not need to engage in complex legal procedures to gain ownership of the collateral which would be the case of a loan against security. The unintended consequence of this practice is outright fictitious money creation.

A simple but absolute truth is that Central Banks do not have the money to buy the Government Bonds (or any other asset) from banks. The Central Bank must borrow that money. The fantastic part about Central Bank borrowings is that they never pay interest because they do not have to negotiate the loan with the providers of the loan. They simply take it at will. Be amazed at the simplicity and duplicity of the process.

The Central Bank will simply create a money credit for the bank in exchange for the Government Stock. It is a “loan” against the inherent wealth in the economy. Even better the Central Bank gets to earn interest from the bank on the money that it granted itself on an interest free basis. Ever wondered how Central Banks “earns income” to finance their own activities, this is how it’s done – earning interest by diluting our wealth. Accounting rules based on “substance over form” allows banks to show “assets under repurchase agreements” still as their own assets and requires a contra “loans from the Central Bank” to be shown on the liabilities side. Here is where my teenage daughter would comment, “How cool is that!”

It all happens because Central Banks do not need to ask anybody for a loan. The Central Bank can simply borrow purchasing power from the economy without anybody’s permission. That is macroeconomic talk for the Central Bank can borrow money form each and every economic participant through money creation. It is what happens every time that the Central Bank enters into a repurchase agreement with a bank (it’s called it providing liquidity to banks).

Interesting how the Melamine Money can fool the economy into believing that purchasing power has not been compromised. The objective has been achieved, successful dilution without detection.

Melamine is described as a compound with low toxicity. That makes it no less deadly. The initial dose will not cause kidney failure, nor the next but eventually it will be achieved. The characteristic which gets you is the fact that it is accumulating. Acute kidney failure occurs after acute exposure to melamine. It is the same with the economy and money creation. It never leaves the system and it can never be digested, so it accumulates in bubble formation and excessive speculative activities. Then the bubble markets fail and the market experience systemic failure. Banks start dying because they suckle on too much Melamine Money.

The answer from monetary and treasury authorities is to increase the dosage of Melamine Money and distribute it as bailouts to all and sundry. Distribution by the Central Bank happens through liquidity provision; and buying more Central Government Securities with money created from nothing will allow Treasury to engage in bailout activities. Consider for instance that the bailouts have now been extended even to the suppliers of goods and services to the auto industry. The source of all bailouts is Melamine Money.

So the patient has been placed on life support and given a melamine drip. No recovery is immanent. The economy goes into a slow death, just look at the Japanese economy. Their melamine money was initially introduced in too large quantities to sustain an export orientated, undervalued currency economy. The Melamine Money caused systemic failure. Melamine Money solutions kept a deteriorating economy in a downward spiral of life support and slow death for 19 years from that fateful December 1989 when the Nikkei started its own downward spiral.

The toxic flow from melamine money accumulates and eventually causes systemic failure. Ultimately Central Government Debt is used to settle all debt but debt just circulates and accumulates in Central Government debt which never seems to be in need of settlement. It sounds like a snake eating itself up from its own tail and grows bigger as a result of the sustenance, because it follows a similar bizarre logic.

Schematically the process can be shown as follows:

The process begins with the issue of Government Bonds.





The Central Bank purchases Government Bonds with Melamine Money (steps 1 & 2). In the normal cause, the Central Bank would again sell the Government Bonds and would sterilise the Melamine Money when it receives payment (steps 3 & 4). The only Melamine Money remaining would then be that for which the Central Bank carries Government Bonds on its own balance sheet.

The Melamine Money is reintroduced when the Central Banks enters into any repurchase agreement(s) with any bank. The introduction of Melamine Money to the economy is accelerated when the Central Bank accepts financial assets other than Government Bonds for repurchase agreements and accelerated again when the Central Banks make outright purchases of financial assets from the banking or non-banking sectors such as purchases of commercial paper.


It is a growth spiral of exchanging debt for debt. Now imagine a process which requires banks to offer a physical good such as gold as collateral asset for a Central Bank repurchase agreement. The act of being forced to purchase gold would sterilise the money creation. The money is “frozen” in gold form. The compounding nature of Melamine Money creation is stopped in its tracks. It should come as no surprise that gold in this context can be called an antidote for Melamine Money poisoning.

I have never understood how thinking such as hereunder could prevail in a sophisticated and enlightened global society such as the one we are living in.

1. “A Central Bank which actually has no money can lend money to Central Government and lately to almost anybody without simply creating “money” from nothing.
2. The “money from nothing” loans can be used to buy real goods and services in the economy without any consequences other than inflation.”

The sci-fi economies usually functions this way, but it is fiction nevertheless. Since this kindergarten variety of economic theory postulates that Central Bank money represents economic value, I would propose that we all stop working and simply demand access to Central Bank money for our purchasing needs. Sadly we will all run around with wagonloads of money but find nothing to purchase since nobody will be producing anything. The economic truth is that Central Bank money has no value other than to temporarily fool the tests for money. Fool the tests for long enough and the economic patient goes into systemic failure and will stay there until the toxic compound is removed from the system.

Inflation is the first symptom of Melamine Money poisoning. Acute Melamine Money poisoning expresses itself as a deflationary depression in the economy. Economic death by Melamine Money poisoning is the final stage in a Hyperinflationary Depression (lots of Melamine Money but no products to buy). Care should be taken with predictions of economic death by monetary poisoning. Japan has shown that the acute monetary poisoning stage can last a long time without the economy slipping into the Zimbabwe example.

No matter how you want to look at it, Melamine Money has no economic nutritional value.

Sarel Oberholster
BCom (Cum Laude) CAIB(SA)
3 January 2009

© Sarel Oberholster

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Note: I will soon publish “War on Savings” which contains a detailed economic theory of the progression of monetary invention through the various inflation stages. I also deal with the consequences of monetary excesses beyond inflation. Please send me an e-mail to ccpt@iafrica.com with “War on Savings – request” and I will provide you with link to a pre-publication copy which I will make available on my blog from 14 January 2009.