The Banking System and Pyramid Schemes: A Comparative Analysis

Abstract

This article aims to explore the hypothesis that the current banking system operates as a large-scale Ponzi pyramid scheme. To achieve this, we will first define and examine the characteristics of Ponzi pyramid schemes and draw parallels between their structure and the handling of capital in the traditional banking system. The Lebanese banking crisis of 2020 and The Credit Crunch of 2008 will be used as a two case studies to illustrate how elements of a pyramid scheme were evident.

1. Introduction: The introduction will provide a background on Ponzi pyramid schemes, their key features, and an overview of the current banking system. It will introduce the hypothesis and the objectives of the study.
2. Ponzi Pyramid Schemes Characteristics and Mechanisms: This section will define Ponzi pyramid schemes, their structure, and how they operate. It will discuss the unsustainable nature of such schemes and their inevitable collapse.
3. Banking System and Handling of Capital: In this section, we will analyse the banking system's approach to handling capital, including fractional reserve banking and interest-based lending. We will draw parallels between the attraction of new deposits to pay off existing debts, similar to the mechanics of pyramid schemes.
4. Case Study 1 - The Lebanese Banking Crisis of 2020: This section will examine the Lebanese banking crisis of 2020 as a real-life example of how elements of a Ponzi pyramid scheme emerged. It will explore the reliance on attracting fresh deposits to cover increasing debt obligations, ultimately leading to a crisis of confidence and a run on banks.
5. Case Study 2 - The Credit Crunch of 2008. This section will examine the Credit Crunch of 2008 as an example of how elements of a Ponzi pyramid scheme emerged triggered by unsustainable banking practice, reliance of continuous credit flows then eventually the crisis of confidence.
6. Analysis and Comparison In this section, we will analyse the similarities and differences between Ponzi pyramid schemes and the traditional banking system. We will evaluate the implications of these findings and draw conclusions based on the evidence presented.
7. Conclusion The conclusion will summarize the key findings and implications of the study.

Introduction

Background On Ponzi Pyramid Schemes and The Current Banking System

A Ponzi pyramid scheme is a deceptive investment scheme that promises high returns to early investors by using funds from subsequent investors, rather than generating legitimate profits. Some Key Features of Ponzi Pyramid Schemes, amongst others, are promise of high returns, unsustainable business model.

The current banking system is a complex financial structure that facilitates various functions, including accepting deposits, granting loans, and providing financial services to individuals and businesses. It operates under a fractional reserve system, where banks are required to hold only a fraction of their customers' deposits as reserves, allowing them to lend out the remaining funds and generate interest income which exposes the system to potential risks and liquidity challenges.

Hypothesis and Objectives of the Study

The hypothesis of this study posits that the current banking system exhibits certain characteristics that are parallel or similar to those of Ponzi pyramid schemes. The study aims to identify and analyse these parallels and their implications for financial stability and investor confidence.

The objectives of the study include:

1. To examine the structural aspects of the current banking system and its operation.
2. To identify key features of Ponzi pyramid schemes and compare them with the banking system's characteristics.
3. To assess the potential risks and vulnerabilities in the banking system that may resemble elements of Ponzi schemes.
4. To analyse real-world examples, such as the Lebanese banking crisis in 2020 and the Credit Crunch of 2008, where Ponzi-like characteristics were evident in the banking system.

By fulfilling these objectives, the study aims to shed light on whether the current banking system can be reasonably compared to a large-scale Ponzi pyramid scheme and the implications of such a comparison for the financial industry.

Ponzi Pyramid Schemes Characteristics and Mechanisms

A Ponzi pyramid scheme is a type of fraudulent investment scheme that operates by promising high returns to investors with little or no risk involved. The scheme is named after Charles Ponzi, who became infamous for employing this fraudulent tactic in the early 20th century. The core characteristic of a Ponzi pyramid scheme is its reliance on the continuous recruitment of new investors to pay off existing ones, creating a pyramid-like structure.

Structure of Ponzi Pyramid Schemes

1. Promised High Returns: The scheme's organizers promise exceptionally high returns on investments, often significantly higher than what legitimate investments can offer. These returns are presented as profits generated through various investment activities, but in reality, they are paid using the funds contributed by new investors.
2. Pyramid-Like Structure: The scheme operates in a pyramid-like structure, with the original promoter or organizer sitting at the top. The initial investors, who are among the first to join the scheme, are positioned just below the organizer. They receive their returns from the investments of subsequent participants.
3. Recruitment of New Investors: As the scheme progresses, the promoter encourages the initial investors to recruit others, expanding the base of the pyramid. The newly recruited participants, in turn, bring in more investors, and the cycle continues.
4. Payments to Early Investors: The profits received by the initial investors are not derived from any actual profitable investments or business activities. Instead, they are paid from the contributions made by newer participants. This creates an illusion of profitability and entices more people to invest.

How Ponzi Pyramid Schemes Operate

1. Attracting New Investors: The organizers use various tactics to attract new investors, such as promising guaranteed returns, downplaying risks, and presenting a compelling narrative about their investment strategies.
2. Paying Early Investors: The scheme pays out the promised returns to early investors using the money contributed by new participants. This creates a false sense of legitimacy and encourages more people to invest.
3. Unsustainable Growth: The scheme's success relies on a constant influx of new investments to pay off existing investors. However, as the number of new recruits required to sustain returns increases, it becomes unsustainable.
4. Collapse: As the scheme grows larger and demands more new investors, it becomes difficult to find enough new participants to sustain the payouts. Eventually, the influx of new funds slows down, leading to a collapse. When the scheme can no longer meet its financial obligations, it unravels, causing significant losses for the majority of investors. 

Unsustainable Nature and Inevitable Collapse

The unsustainable nature of Ponzi pyramid schemes lies in their reliance on exponential growth to generate returns. Since the payouts are not backed by legitimate investments or profits, the scheme cannot be sustained indefinitely. As the pyramid grows larger, it becomes increasingly challenging to find new investors to support the ever-increasing payouts to existing participants.

Ultimately, the scheme collapses when it reaches a point where the number of new investors entering the scheme is insufficient to meet the financial demands of existing investors. At this stage, the scheme cannot sustain itself, and the majority of investors lose their money, while only a few early participants may have received returns at the expense of the later investors. The inevitable collapse is a defining characteristic of Ponzi pyramid schemes, leaving behind a trail of financial ruin for unsuspecting investors.

Banking System and Handling of Capital

The banking system's approach to handling capital involves two key aspects: fractional reserve banking and interest-based lending. These mechanisms play a crucial role in the functioning of the banking system, but they also expose it to vulnerabilities and a reliance on continuous cash flow and consumer trust.

Fractional Reserve Banking

Fractional reserve banking is a system where banks are required to hold only a fraction of their customers' deposits as reserves, while the rest can be lent out to borrowers. For example, if a bank has a reserve requirement of 10%, it must keep 10% of the total deposits on hand in cash or as deposits with the central bank, while the remaining 90% can be used for lending and investments.

Vulnerability and Reliance: Fractional reserve banking creates a vulnerability in the banking system because it relies on a continuous flow of cash inflows from new deposits and borrowers' repayments. Banks need to attract new deposits and borrowers continually to maintain adequate reserves and fulfill their obligations to existing depositors. If there is a sudden decrease in deposits or an increase in loan defaults, banks may face liquidity issues and struggle to meet their financial obligations.

Consumer Trust and Belief: The stability of fractional reserve banking heavily depends on consumer trust and belief in the banking system. Depositors must have confidence that they can access their funds when needed and that the bank is solvent. A loss of trust can trigger a bank run, where a large number of depositors simultaneously withdraw their funds, creating a cash liquidity crisis for the bank.

Interest-Based Lending

Interest-based lending is a fundamental aspect of the banking system. Banks lend money to borrowers, and in return, borrowers are required to pay back the principal amount with interest over time. Interest serves as the banks' primary revenue source and a way to earn a profit.

Vulnerability and Reliance: The banking system's reliance on interest-based lending can lead to a situation where banks need to continuously attract borrowers to generate interest income and maintain profitability. Without a steady flow of borrowers and loan repayments, banks may struggle to generate sufficient revenue to cover operational costs and provide returns to depositors.

Consumer Trust and Belief: Borrowers must have trust and confidence in the banking system's ability to provide fair and transparent lending terms. If borrowers lose faith in the system's integrity or believe that they are being exploited by high-interest rates or hidden fees, they may seek alternative financing options or avoid taking loans altogether, affecting the banks' revenue streams. 

Parallels with Ponzi Pyramid Schemes

The attraction of new deposits to pay off existing debts in the banking system shares similarities with the mechanics of Ponzi pyramid schemes. Both systems rely on a continuous flow of new participants (deposits or investors) to sustain the payouts or repayments to existing participants (depositors or investors). The key difference lies in the fact that the banking system is heavily regulated, and the deposits are used for “legitimate” loans and investments, whereas Ponzi schemes operate on fraudulent promises without any legitimate underlying investments.

However, the vulnerability to a loss of consumer trust and belief is a common aspect. In both systems, once the trust erodes, there is a risk of a sudden and significant withdrawal of funds (deposits) by consumers or investors, leading to a crisis and potential collapse of the system.

Case Study 1: The Lebanese Banking Crisis of 2020

Background

The Lebanese banking crisis of 2020 is a complex and multi-faceted event. The crisis can be traced to a specific event in October 2019, when the Lebanese government defaulted on paying $1.2bn of its sovereign debt. 

This event triggered a run on the banks and loss of confidence in the banking system, as people began to worry that their deposits would not be safe. Depositors rushed to withdraw their money. The banks, in turn, were forced to impose capital controls due to lack of liquid capital, which restricted the amount of money that could be withdrawn or transferred. This made it difficult and sometimes impossible for people to access their savings.

In addition to loss of access to capital, the Lebanese pound plummeted in value from at a rate of £L1,507.5 to the US dollar, before the crisis, to a current nearly £L15,000 to the US dollar, a ten-folds loss of value. This meant that bank deposits lost 90% of their real values.

As a result of the crisis, millions of Lebanese people have lost their savings, pensions, and other assets. Many people have been forced to sell their homes and businesses in order to raise cash. Many businesses defaulted and closed and the unemployment rate skyrocketed to over 50%. Poverty has increased by more than 50%. The government has been forced to implement austerity measures, which have further exacerbated the crisis.

The Lebanese banking crisis has been a humanitarian disaster, with ongoing devastating impact on the lives of millions of ordinary people with devastating results that are expected to last for many years to come.

The Lebanese banking crisis of 2020 shares several similarities with a collapsed Ponzi pyramid scheme:

1. Reliance on Fresh Deposits to Cover Debts: In both the Lebanese banking crisis and a Ponzi pyramid scheme, there is a heavy reliance on attracting new investments or deposits to sustain the system. In the case of the crisis, Lebanese banks offered high interest rates to attract fresh funds from investors, creating an illusion of stability and returns. These high returns were not based on profitable investments but on new deposits, which were used to pay off existing debts and obligations. Similarly, in a Ponzi pyramid scheme, new investments are necessary to pay returns to earlier investors, creating a continuous need for fresh funds to keep the scheme afloat.
2. Crisis of Confidence and Withdrawal of Funds: The default on sovereign debt by the Lebanese government triggered a crisis of confidence in the banking system. Concerned about the safety of their deposits, depositors rushed to withdraw their money, leading to a bank run. This situation mirrors the mechanics of a Ponzi pyramid scheme, where a crisis of confidence leads to a mass withdrawal of funds by investors who fear losing their money. In both cases, the reliance on attracting new deposits or investments becomes unsustainable when people lose trust in the system and seek to protect their savings.
3. Loss of Value and Impact on Ordinary People: The depreciation of the Lebanese pound by almost tenfold during the crisis resulted in a significant loss of value of bank deposits. Depositors' savings lost a large portion of their real value, leading to financial hardship for ordinary people. Similarly, in a Ponzi pyramid scheme, as the scheme collapses, investors lose a substantial portion, if not all, of their investments, impacting their financial well-being.
4. Humanitarian Disaster and Long-lasting Impact: The Lebanese banking crisis has been described as a humanitarian disaster due to the devastating consequences it had on millions of ordinary people. Businesses defaulted and closed, and the unemployment rate soared, leaving many without livelihoods. Similarly, in Ponzi pyramid schemes, when the scheme collapses, it can lead to severe financial losses for investors, impacting their livelihoods and financial stability.

It is important to highlight that the banks involved in the crisis were and continue to be supported by the international establishment and allowed to continue trading and operating despite their role in the crisis. This lack of strict consequences for the banks involved in the crisis is a significant cause of frustration and dissatisfaction among the affected population.

Case Study 2: The Credit Crunch of 2008

The Credit Crunch, also known as the Global Financial Crisis (GFC), was a severe worldwide economic crisis that emerged in 2007 and reached its peak in 2008. The crisis originated in the United States housing market, where the rapid expansion of subprime mortgage lending led to a housing bubble. Financial institutions packaged these risky subprime mortgages into complex financial products known as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).

Unsustainable Banking Practices

Banks and financial institutions engaged in unsustainable lending practices during the build-up to the crisis. The pursuit of higher profits and increased market share led them to offer subprime mortgages to borrowers with weak credit histories and limited ability to repay. These subprime loans were often issued with low or no down payments and adjustable interest rates, which made them highly risky.

Reliance on Continuous Credit Flow

The financial system became heavily reliant on a continuous flow of credit to sustain its operations and profitability. As the housing market boomed, banks were eager to issue more and more mortgages, fuelling a vast network of interconnected financial instruments based on these mortgages. The belief that housing prices would continuously rise led to a false sense of security and the assumption that these risky assets were safe investments.

Emergence of Ponzi-Like Elements

As the housing bubble inflated, the demand for mortgage-backed securities and Collateralized debt obligations (CDOs) increased. Banks created more complex financial products, bundling together riskier assets and repackaging them into new securities. These products were often sold to investors as high-yielding and low-risk, similar to how a Ponzi scheme lures investors with the promise of high returns. In reality, the financial institutions were using new investments to pay off previous investors, just like the mechanics of a Ponzi pyramid scheme.

Crisis of Confidence

By 2007, cracks in the housing market began to appear, leading to a wave of mortgage defaults. As the value of mortgage-backed securities and CDOs plummeted, financial institutions faced massive losses and a liquidity crunch. The interconnectedness of the global financial system magnified the impact, leading to a loss of confidence in the banking sector.

The crisis of confidence triggered a credit freeze, where banks stopped lending to one another and to consumers and businesses. This freeze in credit availability further exacerbated the crisis and triggered a deep recession that spread globally.

Governments around the world provided financial assistance to troubled banks through bailouts and support to avoid their collapse. This involved injecting capital into struggling banks to bolster their financial position and prevent bankruptcy. Some of the methods used for this financial support were:

1. Bailouts: Governments provided financial support to failing institutions by using taxpayer funds in the form of direct cash infusions. This injection of capital was aimed at stabilizing the banks' financial positions and preventing them from collapsing.
2. Quantitative Easing: This involved the central bank purchasing financial assets, such as government bonds and mortgage-backed securities, in the open market. By doing so, the central bank created new money electronically, increasing the money supply. Although this practice is sometimes described as "printing money," it does not involve the physical creation of new banknotes. However, the increased money supply could devalue the domestic currency over time.

A quick comparison between the Lebanese Banking Crisis and the Credit Crunch may initially seem different in terms of outcome, but a closer inspection reveals striking similarities in their impact on the public.

In the case of the Lebanese Banking Crisis, the government lacked the financial ability to provide quantitative easing or bail out the banks. As a result, there was an immediate loss of capital value, leading to devastating consequences for the public. The lack of government support left depositors and investors facing significant losses, and the immediate effect was a sudden and severe blow to the public's financial security.

On the other hand, during the Credit Crunch, governments used public funds to stabilize the financial system. While this intervention prevented an immediate collapse of the banking sector, it came at a significant cost to the public as the tax payers’ money was spent on banks instead of school, hospitals and roads. The practice of quantitative easing, over time, is likely to have led to the devaluation of the currency and inflation means a prolonged and gradual erosion of the public's purchasing power and economic well-being spreading over many years and generation to come.

In both instances, financial institutions were allowed to continue their practices despite their role in the crises. This lack of accountability and regulatory enforcement raises concerns about the protection of public interests and the concentration of power in the hands of financial institutions.

Analysis of Similarities and Differences

The two case studies highlighted significant similarities between Ponzi Pyramid Schemes and the Traditional Banking System, which will be summarized here. However, differences are also noted.

I. Similarities

Movement of Money: Both Ponzi pyramid schemes and the traditional banking system involve the flow of money. However, the purposes and mechanisms of these movements differ significantly.

Dependency on New Participants: Both systems rely on a constant influx of new participants to sustain their operations. In Ponzi schemes, new investors' money is used to pay returns to earlier investors, while the banking system depends on deposits from customers to finance loans and investments.

II. Differences

Purpose and Intent

a. Traditional Banking System: The traditional primary intent of the banking system is to provide legitimate financial services to the public and support economic growth. This is provided by facilitating financial transactions, lending money to individuals and businesses, and offering investment opportunities.

b. Ponzi Pyramid Schemes: The primary purpose of these schemes is to defraud investors by promising high returns on their investments, which are not based on any legitimate underlying business or profit-generating activity.

Another intention is to enrich the scheme operator at the expense of later investors, leading to an inevitable collapse when new recruits become insufficient to pay returns to existing participants. However, this could also be applied to some banking systems.

Legal and Regulatory Framework

a. Ponzi Pyramid Schemes: Ponzi schemes are illegal and considered fraudulent activities in most jurisdictions. The operators can face criminal charges and significant penalties for deceiving investors.

b. Traditional Banking System: The traditional banking system operates under legal and regulatory framework. Governments and central banks impose regulations intended to protect customers, ensure financial stability, and maintain the integrity of the financial system.

However, history and experience have shown that during times of crisis, regulations are often disregarded or set aside by the very financial institutions that may have instigated the crisis..

Risk and Sustainability

a. Ponzi Pyramid Schemes: These schemes are inherently unsustainable because they rely on a continuous flow of new investors to pay returns to earlier participants. Once recruitment slows down or stops, the scheme collapses, leaving the majority of investors with losses.

b. Traditional Banking System: While banks are also exposed to risks, they employ risk management practices and regulations to mitigate potential issues. Most banking systems focus on long-term sustainability to insure more stability.

Business Continuity

a. Ponzi Schemes: Once authorities discover such schemes or when they collapse due to a lack of new investors, they are promptly shut down by law enforcement agencies. The scheme operators are arrested, and the assets are seized for restitution to victims. As a result, the business continuity of Ponzi schemes is short-lived, and they are entirely eradicated once exposed.

b. Traditional Banking System: When a bank faces financial difficulties or failure, governments and regulatory authorities typically intervene to prevent a total collapse. Measures are taken to support the bank's continuity and prevent a systemic crisis.

Accountability

a. Ponzi Schemes: The operators and promoters are knowingly engaging in fraudulent activities to deceive investors. When the scheme collapses, authorities actively pursue and investigate these individuals. They are held accountable for their actions and are subject to criminal charges for defrauding investors. The legal consequences can lead to imprisonment, fines, and the requirement to repay some of the ill-gotten gains to victims.

b. Traditional Banking System: Executives and directors may not always be held accountable for colossal failures that result in financial crises or substantial losses for the bank and its stakeholders. Instead of facing criminal charges, some may receive lucrative compensation packages and bonuses despite their role in the institution's downfall. This phenomenon is commonly referred to as "too big to fail" or "moral hazard," where executives may take excessive risks, knowing that they will not personally bear the full consequences of their actions.

Conclusion

From this comparative study between Ponzi Pyramid Schemes and the traditional banking system, we find significant similarities and differences.

The study revealed that both Ponzi schemes and the traditional banking system involve the movement of money and rely on a continuous influx of new participants to sustain their operations. However, the purposes and intents of these systems are different. Ponzi schemes are fraudulent and designed to deceive investors.

On the other hand, the traditional banking system is a regulated financial institution that intend to provide essential services to the public. It operates within a legal and regulatory framework imposed by governments to ensure customer protection, financial stability, and compliance with standards.

There have been instances of misconduct, dubious activities, and ethical issues within the banking industry coupled with lack of accountability that akin the traditional banking system to a Ponzi scheme run by financial establishments, supported by governments, and funded by public money. This representation is eroding the public confidence and creating a need for more decentralised, transparent, immutable, and accountable systems.