Financial System Collapse

The global financial crisis (GFC) had brought the global financial system (GFS) close to collapse. Extraordinary measures exhausting much of the available resources were brought to bear to prevent the collapse of the GFS.  But the GFS is a menace to world peace and prosperity and it should be structurally reformed rather than simply saved. With the GFS apparently returning to a “new normal”, efforts to learn the real lessons of the GFC have faded.

Both Canada and Australia have undertaken a review or an inquiry into their own financial systems. Because these countries were least affected by the GFC for similar idiosyncratic reasons, they saw little need for serious reforms of their financial systems. Their situations may be illustrated by a parable:

Once upon a time, a man was unaware that he lived in a flood-prone area. He did not have insurance. A flood came but he was left unscathed. He congratulated himself on his fine judgement. Then another flood came. He lost his house and was swept away.

An important lesson of the GFC which was overlooked, perhaps due to a denial of potential culpability, is that the GFC was not exogenous, but was caused endogenously within the GFS by flawed academic theories and an ineffective system of regulation.

Reform Assumptions

New reforms such as Dodd-Frank Act in the US or Basel III of the Bank for International Settlement (BIS) do not address fundamental fallacies of GFS regulation and have, therefore, left the regulatory architecture essentially unchanged. Only the parameters were altered: regulatory standards were tightened, capital ratios were increased, stress-testing was more frequent and supervision was increased, etc.

Regulation of the GFS depends substantially on complex mathematical models for managing credit risk. The GFC proved that the mathematical models used by banks and rating agencies were grossly inadequate for the purpose of risk management. A detailed investigation into credit risk modelling revealed that existing approaches suffer from many economic fallacies, making their use untenable for the GFS.  Incremental improvements and refinements will not make those models adequate for the purpose, as much more fundamental changes are needed.

The GFC has refuted the fundamental assumptions of GFS regulation under the Basel Accord of the Bank for International Settlement (BIS), because there is no scientific basis for accepting that the mathematical models are adequate for managing credit risk.

Similarly the pricing of derivatives is based on mathematical models using unsound economic assumptions which have never been scientifically validated. In the case of exchange traded derivatives, there is at least the possibility of price discovery from market arbitrage activities. But for over-the-counter (OTC) derivatives - which are typically innovations of financial engineering - there is no way for anyone, including the regulator, to validate prices due to complexity and the lack of transparency of the models.

Market Dysfunction

The key assumption for not regulating the OTC derivatives market is that the free-market should work for well-informed traders.   The OTC transactions are between sophisticated big-bank traders who are assumed to have ample resources and knowledge to look after their own self-interests – they would not be knowingly or easily deceived. In other words, it is assumed that due to the self-interest of well-informed sophisticated participants, regulations are not needed for those markets to function properly.

The fatal flaw to this assumption is that the traders are not transacting with their own money – they are agents on commission trading with other people’s money – the money of depositors, investors, investment managers, pension funds, etc. Doing deals and earning commission are the primary motives of the trading agents even if it means higher costs, more risk and greater losses for their clients (who are usually also managing other people’s money).

The free-market assumption of voluntary exchange for one’s own benefit does not generally apply to financial markets where layers of intermediaries operate creating a wedge between risk and reward in markets leading ultimately to systemic dysfunction.

Model Myths

Pricing by “mark-to-model” may well be pricing by “mark-to-myth”, providing opportunities for fraud in OTC derivatives markets which have a notional value of over $700 trillion (and growing rapidly), as reported voluntarily by banks to BIS. It has not been recognized that, since the OTC derivatives market is where most of the unregulated banking transactions are taking place, it is by far the largest part of the shadow banking system which, usually and misleadingly, refers only to the much smaller non-bank lending between unregulated parties.

Without an accurate knowledge of OTC derivative holdings, the true leverage of a financial institution or that of the whole financial system cannot be properly quantified.  Therefore, regulators cannot possibly know precisely about the risk from leverage of institutions or of the whole system.  Essentially, GFS regulation is impossible when the values and risks of OTC derivatives cannot be verified with objective mathematics.

Mathematics has been confused with science in economics and finance.  There is a general ignorance or ineptitude in mathematics which has created an information asymmetry between those who can and those who cannot do mathematics.  Sophisticated mathematics then provides potential instruments for fraud, which was at the base of many past scandals.

Mathematical models for credit risk and derivatives are assumed to be accurate (or accurate enough) and that regulators have the ability to verify them. This assumption is so defective and dangerous for the GFS that it must be challenged to avoid a financial system collapse. The way the flawed mathematical models (MMs) may lead to financial system collapse comes from several contributing factors:

  • Because of complexity, the MMs cannot be effectively challenged by regulators (who are not MM innovators);
  • Through “mark-to-myth” accounting, the MMs can be used as instruments of fraud and to hide losses;
  • Risks of asset portfolios can be under-estimated through the choice of MMs;
  • Capital requirements can be reduced and leverage increased using MMs without regulators being aware;
  • Systemic leverage and risk can increased without any effective means to measure, monitor or control them by regulators.
  • Important physical markets can be so grossly manipulated through derivatives that distortions lead to serious misallocation of resources resulting in economic dysfunction.

Unless the underlying assumptions of the GFS, its structure and regulation are changed, we are likely to see the financial system collapse - which has so far been avoided. Instead of more regulations to save the inherently flawed GFS, reforms should be directed to simplifying the GFS structure and to reducing its risk and contagion. More details on this and other related issues are contained in a recent submission to the Australian Financial System Inquiry.  In future posts, economic fallacies responsible for the false premises of the GFS will be discussed.

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11 Responses to Financial System Collapse

  1. PeterJB says:

    Another comment on "Economic Theory" and how it is applied, by "economists", of course.

    Defining "Economic Theory": The Banker wins.


    "The missing transactions reflected an effort by some of the largest U.S. banks — including Goldman Sachs, JP Morgan Chase, Citigroup, Bank of America, and Morgan Stanley — to get around new regulations on derivatives enacted in the wake of the financial crisis, say current and former financial regulators."

    "After the crisis, Congress and regulators sought to rein in this risk, and the banks fought back. From 2010 to 2013, when the CFTC was drafting new rules, representatives of the five largest U.S. banks met with the regulator more than 300 times, according to CFTC records. Goldman Sachs attended at least 160 of those meetings."

    "Many of the CFTC employees who were lobbied in these meetings went on to work for banks. Between 2010 and 2013, there were 50 CFTC staffers who met with the top five U.S. banks 10 or more times. Of those 50 staffers, at least 25 now work for the big five or other top swaps-dealing banks, or for law firms and lobbyists representing these banks."

    I have been told that Economic Theory is science and I should accept that, well, I don't and I will not, because, imo, it is merely the principle of barbaric tribal nationalism in action; superstitious claptrap; dead dogma; a priest based control system to suck the energy out of productivity. You can use the movie Matrix as the allegory. I took the red pill before that age of ten.

    I think that humanity is best described today as a fertile soil of proto-Human clay in a churn of timeless poverty, albeit, with great potential subject to circumstances and his own hand. Which is to say "Capital" (to be yet realized).

    If the pursuit of economics is not submitted to the established Principles of scientific scrutiny, civilization will continue its mediocre meander through eternity feeding on the lives of Humanity. Today, "economics" consists of, in excess of, ~30 schools of Theory (opinion). Dr. Bernanke's academic paper, upon which he based / justified his TBTF bailouts and Quantitative Easing Programs, has within the past few weeks, been debunked and found academically wanting, lacking credibility and substance - from within the FedRes Board of Governors.

    Social collapse = economic collapse

    The US has already collapsed socially - has so, for many years and various sectors of the demographic diaspora have devolved into primitive barbarism; primarily the governing authority. The question, to which I have now found the answer to, is why? What are the physics behind this collapse and devolution? And, for the first time, this social upheaval is global. Is this a Phase Transition between major cycles?

    Economics is the study of the metaphysics of the Human Being, and human behaviours and the advancement, and well being of Humanity and civilization through the sciences - or should be, and NOT some politicalized faith based Cult -consisting of over 30 crazed sects in order to protect and evolve the power (read: the corruptive) of the Banking System and all hanging therefrom (which it is today). The Banking System acts as unnatural 'milieu' (environment / encapsulation / collective / capacitor) that subjugates the behaviours of men (and women) through evocation and corruptive power. This is the problem; that is, the physics and nature of the Collective is the problem, as man has not yet evolved to his Humanity (mostly. And Humanity is where Intellect be; beyond the realm of Intelligence. Intellect is the antidote to the corruptive forces of power, and is within the grasp of Man. Intellect, is Mans' Destiny.

    The wealth created from global productivity is being vacuumed through the 'blood funnels' of a few well connected and influential individuals and through a Banking system serving the personal interests of those few and totally supported by the "Economist" and his "Economic Theory". To the Banker, the politician, general, economist and bureaucrats, etc., merely represent a small cost in "doing business; banking business."

    And, this has been going on for ~5,000 years, or more.

    "...the concentration of capital and the growth of their turnover is radically challenging the significance of the banks. Scattered capitalists are transformed into a single collective capitalist. When carrying the current accounts of a few capitalists, the banks, as it were, transact a purely technical and exclusively auxiliary operation.
    When, however, these operations grow to enormous dimensions we find that a handful of monopolists control all the operations, both commercial and industrial, of capitalist society.
    They can, by means of their banking connections."
    -- Vladimir Ilyich Lenin [Vladimir Ilyich Ulyanov] (1870 - 1924), First Leader of the Soviet Union

    Please also note: The Bolsheviks (led by Lenin) were financed primarily by Rothschild. And Leon Trotsky (Bolshevik second in command) was returned to Russia and financed by the Bankers of New York and London). Murdered in wars during the 20th. Century were in excess of ~100 millions members of Humanity. Rothschild collapse the UK Markets by lying about Wellington's defeat of Napoleon at Waterloo so he could buy up equities for pennies on the GB Pound. He who cannot see the behavioural patterns in the Banking System, doesn't want to look.

    Ho hum

    • admin says:

      Regulation of risk management and risk products will never work, because no one, particularly the decision makers, understands the risks - but they do not suffer the consequences.

      Big organizations are run by psychopaths and sociopaths who manage and control people. They are lawyers and MBAs who are often clueless about risk management and risk products. But they assume that it is enough that they control the technical experts and get the necessary information from them.

      Investment banks get highly paid "quants" to create innovative risk products: exotic options, swaps, swaptions etc. The prices of these products are little more than guesstimates, involving unscientific assumptions including the ergodic fallacy: past statistics are assumed same as future statistics etc. Investment banks trade these products with their clients, corporations, hedge funds, pension funds, local governments, etc.

      Goldman Sachs call their clients "bunnies" because they are the victims of their scams. But the victims are not really victims because they are only managing other people's money, the money of the ultimate victims (ordinary people). Countless scandals since 1980s, including Orange County, Gibson Greetings. Metallgesellschaft, Greek government, etc. have been ignored.

      No derivatives pricing models are ever proven scientifically. The mis-pricings could create risk of loss for the investment banks themselves, particularly when they started to compete with each other on similar products and undercut each other to win market share. The risk to banks comes from having one side of each derivative transaction sitting on their own balance sheets.

      Then they developed a way to off-load those risks from their balance sheets by selling their sides of transactions to unwary investors in a process called securitization - generating riskless profits from commissions. Mortgage securitization of subprime loans, derivatives on derivatives, etc. were the triggers for the global financial crisis (GFC).

      Regulators are clueless in all of this, because there are no laws governing any of these "innovations", as regulation is essentially law enforcement. It takes years to draft legislation, having exposed to industry discussion, debate amendments, set regulatory procedures, etc. For example, seven years after the GFC, the reactive legislation is far from settled:!/risk_intelligence_detail/a1Z40000002wJDWEA2

      My ten years of work experience with financial regulation indicate the situation is hopeless. Lawyers have not even come to an agreed definition on "derivative" and hence no "in principle" broad legal framework is possible. There will always be "bloodhounds chasing greyhounds" in specific product regulation. There is very little genuine understanding of finance in the industry, least of all among regulators.

      University academics have been training lots of "quants", because of well-paid job opportunities in the industry. All they are doing is supporting an industry of frauds and scams. This is why unscientific economics taught at universities has a lot to answer for. In the absence of adequate and scientific proven knowledge of risk, revival of the Glass-Steagall legislation is imperative.

  2. PeterJB says:

    May the interpretation of all this "innovation" and "bunny" scamming, and other such delightful activities not be classified as "FRAUD"?

    Yes certainly, to the revival of Glass-Steagall, but not while the "neocons" which seems to be supporting Summers, Rubin and the majority of those governors of the FedRes; indeed, all or most Central Bankers and influential Economists. Not while the current and future administrations of the USA are empowered in the current milieu. There needs to be some shock therapy for the introduction of objective reason and economic science on behalf of all Humanity; but, those entrenched are too firmly dug-in.

    What does Wall Street and the "markets" do? Can it be defined as "economics"?

    I have said above: "Economics is the study of the metaphysics of the Human Being, and human behaviours and the advancement, and well being of Humanity and civilization through the sciences - or should be..." whereas, as you state, this is not the case, as the "Regulators are clueless in all of this, because there are no laws governing any of these "innovations", as regulation is essentially law enforcement."

    Where then, is "economics" in any of this?

    Perhaps then we should re-classify "economics" as the practice of Applied Fraud? The disconnect between "economics" and Applied Fraud is obviously wide indeed, or are they both of the same illusion. At least then perhaps the Regulators could receive the necessary training to serve Society, Humanity and Civilization? Yes, the proto-Human is generally easily corrupted and often, eagerly corrupted, and this condition is fundamental to the nature of the Collective as accordingly noted by Philosophers of note over millennium since before Lao Tze and Nietzsche and the like. Does this not mean then, as I have been saying all along, those who 'control-the-money' by "Economic Theory", have a far different play book, to those who regulate by "Economic Theory" - where the latter do not comprehend the former, but the former understand precisely the latter?

    Or, the Banking System does as it likes, the other do as they are told.

    Thank you for your validation.


    • admin says:

      Sorry. Goldman Sachs frequently calls its clients "muppets" (rarely bunnies). To take money off muppets is "doing God's work", which explains why Lloyd Blankfein has recently joined the club of billionaires, instead of going to jail.

      Economics (more precisely the mainstream economic paradigm) is a mixed bag or a pluralism of inconsistent beliefs which pretends to be science. Economic education is a "9,000 pound lobotomy" of critical thinking and replaced with theology set out in standard textbooks.

      Regulators are the last to question accepted beliefs. When I presented empirical evidence to the contrary, suppression and relegation were the rewards for "rocking the boat".

      As regulators, it is better to fail conventionally than to succeed unconventionally. When failures inevitably happen, regulators are rewarded with more resources and bigger budgets for new regulatory initiatives to combat "new" crimes.

      Few understand that a regulator's activities are strictly defined and circumscribed by its annual budgets. There is little room for flexibility or pro-activity in a bureaucracy. Civil service has been designed since time immemorial for inertness and stability.

      Do not expect regulators to protect you from innovative frauds and scams which have not yet been outlawed. The Banking System does what it likes (1) by funding the economic research which favors lobotomy: e.g. "efficient markets" and deregulation and (2) by creating innovative (but not yet illegal) ways to defraud the public (e.g. high frequency trading aka front-running clients).

  3. PeterJB says:

    Thanks for confirming "moppets" and not "bunnies" - I had thought that I missed something.

    I am reminded of the age old saying: Women and cats do as they wish; men and dogs, do as they are told.

    And another: The definition of evils is 1000 thoughtless but efficient bureaucrats.

    Thank you - all the above shows clearly and unarguably, that no reform of the system of "economics" is possible, without a complete collapse, as the "elite" and their vested interests are too deeply entrenched and the "unwashed" too brainwashed.

    The Banker is King and His Word is the Law

    Long Live the King

    Interesting times. I feel privileged.


  4. admin says:

    This post was based on a submission to the Australian Financial System Inquiry, available here:

    or here:

    As expected, the lessons of the global financial crisis (GFC) have not been learned by the authorities and nothing much has changed in financial regulation, notwithstanding Basel III, Dodd-Frank Act, etc. all of which are "putting lipstick on a pig". The evidence of "business as usual" in financial regulation can be found in a recent speech by the chair of the Australian Prudential Regulation Authority (APRA):

    The final sentence of the speech reads:

    If we are going to match expectations with reality, we have a choice: to lower our expectations in these area, or to improve what happens in practice. I prefer the latter.

    That is to improve reality or what happens in practice. Unfortunately, what happens in practice has not been improvements. As we argued in this post there cannot possibly be significant improvements any time soon, because of deep-seated problems in economic and financial knowledge - most of it is unscientific.

    Improvements have not occurred, with scandal after scandal: Orange County, Gibson Greetings, Metallgesellschaft, Long-term Capital Management, Asian financial crisis, Y2K, dotcom bubble, Enron, Worldcom, subprime mortgage crisis and the list goes on. In fact, each crisis progressively became more and more serious and widespread than the last.

    None of the credit rating agencies or major banks with their Internal Rating Based (IRB) models saw the GFC coming for the simple reason that they all have to make the ergodic assumption: past statistics is same as future statistics. The credit default forecasts leading to the GFC were based on the historical default rates since the Great Moderation. The credit risk models used are all statistical (reduced form) models with zero understanding of causality (Sy, 2008).

    Our expectation from financial regulators and central banks is to protect us from fraud, malfeasance, incompetence, systemic crisis, etc. Instead they create false confidence. Our expectation has been dashed time after time and each time improvements have been promised but never delivered. Improvements have not occurred because the people and authorities who make those promises have little idea of what it takes to improve actually, because they are not the doers - they are politicians and bureaucrats.

    It will take a long time, if ever, for financial institutions to be able to manage risk and uncertainty with any accuracy or efficiency. One of many reasons being "Black Swans" (Taleb, 2007). Pretending that they can do what they really cannot, and have ignorant regulators fooled, puts the world in great danger. The risk of financial system collapse is multiplied enormously. Individuals should lower their expectations from regulation, because there will be no material improvement in protection.

  5. PeterJB says:

    You state: "Improvements have not occurred because the people and authorities who make those promises have little idea of what it takes to improve actually, because they are not the doers - they are politicians and bureaucrats."

    Au contraire, "improvements have occurred, but alas, in the innovations, sophisticates, nuances and collaborations between regulators, the political ends, the bureaucratic eagerly stated blindnesses - and revolving doors, delusional securitizations and accompanying mathematics of meaningless tripe, deep penetration trading algorithms, etc., etc., all, in those areas where "... Our expectation from financial regulators and central banks is to protect us from fraud, malfeasance, incompetence, systemic crisis, etc." Yes, "... fraud, malfeasance, incompetence, systemic crisis, etc.", has improved considerably through the well-oiled collaborations of all Party's concerned.

    Armstrong reports in the face of the utter complete failure of cyber intrusions into every citizen of the World's computers and Internet devices, to "keep us safe", that these cyber intrusions are indeed nothing more but to stealth intercept taxation, blackmail, and totalitarian imposed control. Increased Taxation is the cry of the "ruling elite" globally echoed and the Banking system is demanding the end of cash, the backbone of capitalism; and higher percentages of all available caches of cash, - clearly they want it all, as well as assisted via False Flags and propaganda being propagated by the MSM, its talking heads and basement 'dollar a day, junk, on-line "journalists".

    But take heart, the system of the global schemers is broken and this is, after all, Q4 2015, that time of payback. The 1% are losing their "wealth" and the Banks are fully exposed as Bankrupt-Beyond-Belief, that is, desperation; their rule of glory is at the end. You might say, self-Corzined. Perhaps it is about time that they Madoffize and throw themselves on the Mercy of the Gods

    Now there cometh pain, and the Dawn of another delightful Day; to each his/her own.

    Ho hum

  6. admin says:

    The improvements I refer to are improvements to models, which are flawed, but continue to be accepted by banking regulators.

    Credit risk models, economic forecast models (e.g. DSGE), trading systems for futures, stocks, etc, betting systems for horse racing, gaming, etc. may look sophisticated. Their sophistication and complexity are there to deceive the uneducated. The uninformed public treat them as "black boxes" which work like the TV they switch on every night.

    The models are used by dishonest individuals and institutions to pretend that they have useful instruments for the services they provide. The bigger the model, with more variables, equations, statistical data, etc. the more convincing is the deception.

    These models do not work. Logically they do not work if one examines the details of how they are constructed, because they are based on logical and material fallacies. Empirically the facts show they do not work, if one observes the enormous errors (e.g. in multiples of standard deviations) in actual practice. For example, credit default rates were several multiples higher than model predictions in the GFC. Central bank DSGE models produced growth forecasts which were consistently and substantially biased to the upside for the past several years after the GFC.

    By any objective criterion, they are unscientific, because the fact that they have failed their own tests does matter in science. For anyone to take any further notice of those models, there have to be:

      1. A convincing diagnosis of the causes of failure of the models
      2. Appropriate modifications to repair the faults of the models
      3. Proof that the new models would have produced the correct results by retrodiction (e.g. input data before 2008 would have produced outputs of actual data after 2008)

    These steps have not been carried out and the regulators are claiming there have been improvements. Models are great because they provide objective discipline to decision making, but only if they work. If they don't work then they can mislead us to disasters like the GFC or even worse in the future.

  7. PeterJB says:

    Expect: "... or even worse in the future." And, I refer to the near term future which began in Q4 2015 (this round).

    Your explanation is correct, without doubt, but what does this mean? - I wonder, as there are those that have correctly concluded, as you.

    What does this mean?

    Ho hum

  8. PeterJB says:

    If you follow the spoor, in this World of financial markets (for want of a better expression) in order to find meaning, then you must follow the lies - as lies are the source of meaning, and then you find there is little but lies; then you have arrived at your answer.

    But this answer can be found at the track, where it is always a good bet, that all the horses have been doped. Then, one looks, not at the horse but the owners, and what is behind those owners such as debt, connections, ambitions, payoffs, government favors, etc., in order to find which horse will win, or even more critically, which horse will definitely lose, and at what odds and margin. The race continues until exhausted and the change sets in. Boredom.

    Alexander rode in front of his army and caravan (to primarily stay out of the dust and away from the sniveling noise of snotty nosed children and the banging of pots and pans), and today, those who would have you believe are in command, and not in front, and not in fact to be seen. Why? Civilization is defined by Fear and Cowardice. Message: Follow the lies.

    I should add that there is little similar in the mechanics of the Markets and Economics. I have no interests in markets, but more in economics, which I maintain is the expression of human behaviours. And where these Human Behaviours are not only misunderstood, incorrectly defined and worse, not accounted for correctly in the art of conjuring social constraints ie governance. It is no wonder economics is a mess, as the fundamentals of human behaviours are also biased in favour of the biased.

    On the other hand, most appear to have only an interest in markets. This is no criticism at all; we all have our preferences, which is the way things should be; but we do, err, in assuming that our interests are identical.

    The FedRes decision to hike (non hike) 0.25% is biased to the markets only, what else?, as this is why the the FedRes exists and certainly not, a priori (unless you believe those political lies that were and are used in favour of the FedRes, over "main-street".

    Here is the lie and its meaning. The FedRes exists for the markets and hence the Banks (and all attached) to suck up anything of value - that is to say, "money" or fiat, assets and power, wherever it may be; centralization, or in strict observation of the Laws of the Universe, ie Thermodynamics, Entropy - ONLY. It is in 'human speak', Totalitarianism.

    And Yes, it is the way things are for the moment, but please note, it has not been as accelerated as it is now, and will not be, in the near future. What does this infer? Answer: As history clearly shows: Humans are Capital to be Harvested.

    • admin says:

      It is self-evident that some power-hungry psychopaths are running the world. How many, we don't know. But what we do know is that there are plenty of good people. However, evil triumphs when good people remain silent. The education system has been lobotomizing students and turning out idiots (including central bankers and government officials) who can parrot a lot of stuff they have learned by rote at university. Here is a sample from Ami Horowitz:

      The only course of action is for the good people to speak up to tell the truth and to prove to politicians, academics and media that their propaganda (knowingly or unknowingly) are false and destructive, leading the world down the toilet. To be able to do this, protection of the First Amendment in the US Constitution is vital and now fear of terrorism is being used to repeal it.

      "In a time of universal deceit - telling the truth is a revolutionary act." - attributed without verification to George Orwell. Therefore economic science is a revolution.

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