Abolish deposit insurance, please

This crises has taken its toll on livelihoods of many people. But it’s also making otherwise reasonable and balanced investors lose the plot and move from investing to preaching.

I have found myself in a surprising situation lately – I inadvertently became the only person on my twitter feed who does not condemn Jeroen Dijsselbloem. Now, I like being controversial like the next man (anyone who ever tried to talk to me about Hungary can testify that) but this time around I have had to endure more abuses than normally.

I am sure many of you still have in mind “the Cyprus debacle”. If not, please start with an excellent piece from Joseph Cotterill entitled “A stupid idea whose time had to come” and work your way through links. The title of Joe’s piece has stuck in my mind ever since and I finally have a few moments to explain why.

To be sure, I do not contest the fact that the EU outdid itself and managed to make their communication even muddier than usual. But this is now behind us and we should focus on the essence rather than on the way the package was announced. I may have mentioned that in the old days I was quite involved in Iceland’s banking crisis of 2008. And I have always claimed that – despite a few minor hiccups on the way – letting the big banks default and closing the capital account was the right thing to do. I think there are many similarities between Iceland and Cyprus and that’s why I believe that bailing-in the (foreign to a large extent) depositors was the correct course of action. I mean of course the final solution, not the initial idea of not sparing smaller deposits, which was plain ridiculous. Yet, ever since the announcement I had to argue with people who were throwing all sort of populist arguments and who went into great length in finding ways to insult Jeroen Dijsselbloem. Jeroen Dijsselbloem who is a politician trying – like all of them – to get reelected and who understands that top priority in a support package for any country must include ways to prevent citizens of core European nations from revolting.

But instead of spending time explaining why I think the Cyprus solution was a correct one*, I thought I would touch on a somewhat more medium term issue, which is deposit insurance. This is because I think the debate in Europe whether to centralise the deposit insurance scheme or keep it on the national level is a wrong kind of discussion. I think that we should begin to discuss whether one of the lessons from the crisis shouldn’t be to cancel deposit insurance altogether.

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Deposit insurance was introduced in the US in 1933 (earlier it was created in Czechoslovakia). The idea was to restore faith in the financial system and get banks to lend more. This was the idea whose time had to come. And it wasn’t stupid at the time but rather necessary. Since then a lot of things have changed, though. For starters, the world has seen a remarkable ascent of investment banks, which have benefited quite a bit from deposit insurance. This was at times coupled by quite a bit of recklessness in the way banks’ balance sheets were used and this is now widely recognised. Perhaps all-too widely.

Think about it – we just witnessed a full-blown bank holiday in a country which is relatively small but which was in the spotlight for at least a fortnight. During that time I even recall one of the macro tourists hedge fund guys who said that the best thing to do at the moment was to put live cameras in front of banks in Milan and Madrid because “the end is nigh”. Of course none of that happened and we probably need to entertain the idea that people in the street are not completely dumb, as difficult as it may sound…

But why didn’t we have a run on other European banks? I think most of the Europeans understood that the bail-in in Cyprus was due to the fact that there was a lot of foreign and most probably dirty money there. Heck, even the average person in Cyprus seems to have comprehended that problems at Laiki were pretty specific to Laiki. True, the capital account remains shut and it will probably stay like that for a while but it’s really not a big deal in the greater scheme of things.

When I first tweeted about the idea of abolishing deposit insurance, the replies I received pointed out that it could topple the whole financial system. There is some truth in it. After all, if the deposit insurance was to be abolished as of tomorrow, many people would probably go to ATMs “just in case”. But let’s try and work out the logistics of the issue. First of all, most European countries guarantee deposits up to €100k in full. This seems to be working even though there are quite a few governments who could not possibly meet this obligation if required, just like Cyprus. So it’s one of those barrier-type option hedging products that stops working precisely when you need it. Another question is why 100k? It’s a round number and nothing else, because the average deposit is way below that level. And if that’s the case then would it change much if we reduced the limit to 99,999.99€? With the exception of the holier-than-thou folk in the media who would immolate over the concept, probably not much.

Let’s take it a step further. What if Europe announced the following:

  1. As of January 1, 2014, all the countries within the Eurozone will be jointly responsible for insuring any deposit up to 100,000€.
  2. Starting from January 1, 2015 the limit will go down by 10,000€ every year until it goes down to zero on January 1, 2024, after which no deposit will be guaranteed by any Member State.
  3. (repetition) Governments and national central banks of Member States will irrevocably guarantee the insurance with their full faith and credit until January 1, 2024.

I would argue that the average person in the street would probably be interested to browse through front pages of various newspapers which would be “shocked and dismayed” but since they don’t have anything close to 100,000€, they would probably only calculate when their savings could potentially become vulnerable. What would be far more interesting is the reaction of banks. After all, even in core countries like Germany, the Netherlands or France “some banks are better than others”. There’s no need to point them out – they are perfectly aware of their own situation. After such a change in the system they would know they have several years to build up the sufficient capital buffer and to improve their books or else… In other words, Europe wouldn’t place those institutions under an imminent threat of a rapid deposit withdrawal but would send a strong signal that the clock is (slowly) ticking. Sure, there would probably be some turbulence in the cost of bank funding but I don’t believe that would be fatal. Simultaneously, the banks would have to voluntarily cut their riskiest and most balance sheet consuming operations in trading. No need for financial transaction tax, bonus caps or short-sale bans.

I know that what I described may sound a bit like science fiction but we have just gone through something that was seemingly unthinkable only a few months ago, i.e. haircutting desposits and shutting the capital account within the Eurozone. And guess what – not much has happened. So instead of throwing calumnies at Jeroen Dijsselbloem consider that if we stop here then it will mean that we (Europe) have just sent a signal to people that they can keep money in however crappy bank they want as long as it’s less than 100,000€. Alternatively, we could give the banks’ customers and the banks themselves a friendly nudge with a not-too-close deadline and let the market forces work their magic. Remember, systemic ain’t what it used to be. Let’s take advantage of that.

* By the way, don’t even try to assume that I think every single country in trouble should be dealt with in the same way as Cyprus.

19 thoughts on “Abolish deposit insurance, please

  1. While I don’t fully agree with your idea, I did have thoughts along the same lines (http://investhalal.blogspot.com/2013/03/lessons-of-cyprus-and-depositor.html), except as it relates to Islamic finance. In most banks, the depositors are all lumped in as a special type of liability, effectively senior to the debt holders in the bank and to the equity. There is a presumption for depositors that they are fully insured up to whatever limit is set, and then beyond that, they will take whatever value remains in the bank’s assets. There is unlikely to be a connection between any of the bank’s specific assets and there deposits, whether they have a current account or a 5-year CD.

    What could be set up (but is not currently, except for one case; more on that below) would be to tie specific assets to specific depositors, shifting the mix of assets between higher risk/higher return (for longer-term CD depositors) and lower risk/lower returns (for current account holders for whom presumably return of capital is the primary objective). The reason I bring Islamic finance into the mix is that there is a case where at least in part, the regulations have shifted to make specific asset pools linked to specific depositors. The State Bank of Pakistan last fall issued rules that requires Islamic banks to separate out their deposits into specific pools each which have separate investment objectives and liquidity constraints.

    This makes the bank a bit more complex, and subjects the whole process to the requirement that the central bank can adequately regulate the different pools, but in theory, this would provide a more transparent method that would probably allow depositors to more fully monitor their deposits risk to principal. Of course, the more known this is, the more likely it is to accentuate a self-reinforcing cycle from illiquidity to insolvency, but presumably if an institution is going to fail, giving the ability for it to be shut sooner before the problems fester too long will in many cases reduce the losses compared to a bank that is allowed to continue papering over deposit outflows for years.

  2. Thank you very much for your posts always thought provoking, especially this one. Just out of curiosity, could you just name a couple of Banks that you think are doing a good job ib terms of trimming risk? I know *what are the safe banks* is a ‘washy question’ but just looking for a feel of some of the ones that are trying to be ahead of the curve in your eyes… thanks!

    • hi. thanks for the comment. i do have my “list” but i prefer not to reveal it as going into specific names is asking for trouble, even when one’s anonymous.
      but check out who extended duration the most and who shrank balance sheet in investment banks the most

  3. I congratulate you on your stance towards the Iceland and Cyprus crisis. To solve a banking crisis, you need to be able to read a balance sheet. If assets are impaired, liabilities need to be matched and if there are not enough unsecured and secured bond holders in the way then deposits will have to be hit. Another option is to shrink the balance sheet by taking the impaired assets off at fantasy prices, which happened with TARP in the US; essentially a subsidy to an insolvent, fraudulent banking sector.
    Regarding deposit insurance I think it is in breadth a necessary corollary of fractional reserve banking. The ability of banks to lend out deposits, which on their statements customers regard as their ready cash (us mere mortals use commercial bank money as our means of payment and investing liquidity) requires a lender of last resort and a credible commitment by the supervising authorities to backstop the average consumers account. The eventual liability is the only lever which keeps authorities interested in leashing their banks. No one wants to revisit the scramble for bank notes and gold witnessed in the 30s, before deposit insurance had been created. It is necessary though to limit banks ability to hazard this protected capital (insured by another entity) without paying for the insurance.

    Deposit insurance needs to be limited and reformed, but not abolished. You can only do that if you move to a fully reserved banking system, which is possible, but requires a paradigm shift. I suggest reading Prof. Huerta de Soto on it.

  4. The 100k limit is because the EU has used its infinite wisdom to determine that 100k is *fair* you should know this!

    If I’ve understood correctly your argument for abolishing deposit insurance is that it would weed out weak banks and/or force them to strengthen their balance sheets, making the whole system healthier. But it’s not clear to me that this is really what would happen.

    US deposit insurance was introduced to put an end to the endemic bank runs which plagued the sector, and there is at least a good chance that were it abolished, that instability would reappear. In return, we get less moral hazard and a more Darwinism. It would have to be seen if the social benefits of the latter outweigh the costs of the former. I personally have my doubts that an economy infested with bank runs can create more wealth because it’s harsher on under-performers (which are already penalized even with deposit insurance) than the alternative.

    You are correct in pointing out that the investment banking sector has used this protection to get cheap funding and increase their leverage. This could be solved however by segregating investment banking from commercial banking, which, after all, is hardly a new idea or controversial idea.

    At a practical level, many small EU banks that operate at a national or regional level have their assets tied up in loans to locals, or with the sovereign. They don’t have much capacity to diversify away from assets which are highly correlated and intimately linked to the local economy. On the liability side, how can they build up capital buffers when objectively their assets are so unattractive that no-one would invest in them without a political motive or some form of protection?

    So the question is, should they fail because of this? Their predicament has more to do with the fact that they operate within a dysfunctional currency union which is destroying half of Europe’s economy while simultaneously putting the other half on steroids, rather than some fundamental economic non-viability issue with the businesses they lend to. I think the underlying reasoning is that the storm will eventually blow over, further integration will eventually be pursued and so from the Southern countries’ point of view it’s just a question of trying to prevent the economy from being irreversibly ravaged in the meantime. Deposit insurance is a form of subsidy to weak banks because it lowers their funding costs, and indirectly it’s a subsidy to weak local economies.

  5. Your ideas sound very logical and rational, but I do not think that people would actually act in the way that you describe.

    I don’t think that people within the banks are making their decisions based on the idea that the depositors are protected up to a certain limit. If the deposit insurance were withdrawn I think that the depositors would not be sufficiently sophisticated to make an informed choice about which institutions were genuinely strong and would stay at whichever bank they were currently using. The banks would put pressure on their risk managers to “prove” that the institutions were safe using their Excel spreadsheets, but not actually change their actions. Their weakness came from relying on faulty risk models and thinking that they were safe, rather than knowing that they were taking big risks, but backstopped by the deposit guarantee.

    Then, if and when the bank failed it would guarantee more panic among the depositors who would then complain bitterly to the government and/or regulators that this situation never should have been allowed to happen, rather than thinnking that they should have checked the balance sheet and capital position of their bank.

  6. Your suggestion is not that radical; New Zealand don’t have deposit insurance. But I dont think they are altogether happy with the situation, if you ask the averange depositor. See this for the reserve banks view: http://www.rbnz.govt.nz/speeches/5218305.html
    And remember, coninsurance proved fatal in the UK during the Northern Rock crisis. So the issue is rather depositor preference in policy discussions today, in contrast to eliminating it altogether.

  7. With all due respect, your history is lacking. Deposit insurance in the US was created primarily to prevent bank runs, and to discourage the kind of rumor-mongering that caused bank runs. One wonderful consequence was to promote lending, but that was only peripheral. Deposit insurance filled the information gap that existed between the general public and supposedly better-informed rumor-mongers who were repeatedly collapsing small local banks across the US.

    Deposit insurance has myriad benefits, notably taking the risk-analysis burden from an average person (who may have little to no understanding of bank risk), and transferring that oversight to a regulator. As banking gets more complicated, even regulators have a hard time keeping up. Imagine how the public would feel if they had to conduct bank examinations every time they made a deposit.

    “But, Matthew, if people were required to do their own risk analysis, banks would have to be less risky and more transparent,” you say.

    Fair enough, but that’s insufficient. Regardless how transparent and risk-free a bank is, there will always be an information gap.

    Imagine if a David Einhorn-type put together a presentation attacking XYZ bank as ticking time-bomb, and warning everyone to “get out while you still have time.” Even WITH deposit insurance, XYZ bank would be subject to immense pressure, but such attacks rarely succeed. Without deposit insurance, utter chaos would ensue, and the public at large would suffer.

    If you can get your history right, perhaps your conclusions would not be different, but your arguments would be more sound.

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