Good riddance to deposit ‘insurance’

hands exchanging euros

Image by Stuart Miles

Once the public furor and shrill media coverage have died down it will become clear that events in Cyprus did not mark the death of democracy or the end of the euro but potentially the beginning of the end of deposit ‘insurance’. If so, then three cheers to that. It may herald a return to honesty, transparency and responsibility in banking.

Let us start by looking at some of the facts of deposit banking: When you deposit money in a bank you forfeit ownership of money and gain ownership of a claim against the bank – a claim for instant repayment of money but a claim nonetheless. In 1848 the House of Lords stated it thus:

“Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it…The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.”

This is not legal pedantry or just a matter of opinion but logical necessity that follows inescapably from how deposit banking has developed, how it was practiced in 1848 and how it is still practiced today. If ownership of the money had not passed from depositor to banker than the banker could not lend the money to a third party against interest and he could not pay interest to the depositor. If the depositor had retained full ownership of the deposited money, the banker would only be allowed to store it safely and to probably charge the depositor for the safe-keeping of his property. Money stored in a bank’s vault earns as little interest as money kept under a mattress. It is evidently not what bank depositors contract for. If interest is being paid – or ‘free’ banking services are being provided – the depositor must have agreed –at least implicitly – that the banker can ‘invest’ the money, i.e. put it at risk.

For more than 300 years banks have been in the business of funding loans that are risky and illiquid with deposits that are supposed to be safe and instantly redeemable. When banks fail depositors lose money, although in former times, sturdier and more honest, no rational person claimed that the depositors were unfairly ‘bailed in’ or were the victims of ‘theft’.

Although the mechanics of fractional-reserve banking have not changed in 300 years the public’s expectations have evidently changed greatly.  Today banks are expected to lend ever more generously while depositors are supposed to not incur any risk of loss at all. This means squaring the circle but it has not stopped politicians from promising just such a feat: Enter deposit insurance. State deposit “insurance” is not insurance at all. Insurance companies calculate and calibrate risks, charge the insured party and set aside capital for when the insured event occurs. A state deposit ‘guarantee’, by contrast, is simply another unfunded government promise, extended in the hope that things won’t get that bad. When they finally do the state does what it always does: it will take from Peter to pay Paul. Cyprus is a case in point: Private insurance companies would have pulled the plug on a ballooning banking sector long ago while the Cypriot state, still the local monopolist of bank licensing and bank regulation, evidently looked on as the banks amassed deposits of four times GDP. In the end Cyprus’ government ran out of ‘Pauls’ to stick the bill to – and ‘Hans’ in Germany refused to get ‘bailed in’ completely (although he is still providing the lion’s share of the bailout).

Cyprus is just an extreme example of what the institutionalized obfuscation of risk and accountability that comes with state-protected banking can lead to. Deposit ‘insurance’ masks the risks and socializes the costs of fractional-reserve banking. Unlimited state paper money and central banks that assume the role of  “lenders of last resort” have the same effect. If the original idea behind these innovations was to make banking safer, it has not worked, as banks have become bigger and riskier than ever before, although I suspect that the real purpose of these ‘safety nets’ has always been to provide cover for more generous bank credit expansion.

Under present arrangements there is little incentive for banks to position themselves in the marketplace as particularly conservative. Depositors have been largely desensitized to the risks inherent in banking. They no longer reward prudent banks with inflows and punish overtly risky banks with the withdrawal of funds, and even if they do, the banks can now obtain almost unlimited funds from the central bank, at least as long as they have any asset that the central bank is willing to ‘monetize’. This is a low hurdle indeed as banks have become conduits for the never-ending policy of ‘stimulus’ and are thus being fattened further for the sake of more growth. Once a bank has ‘ticked the boxes’ and meets the minimum criteria of regulatory supervision, any additional probity would only subtract from potential shareholder returns. Our modern financial infrastructure has created an illusion of safety coupled with an illusion of prosperity thanks to artificially cheapened credit. The risk of the occasional run on an individual bank has now been replaced with the acute and rising risk of a run on the entire system.

This would change radically if we reintroduced free market principles into banking. Bankers would again be answerable to all their lenders, including small depositors, who would no longer be lulled into a false sense of security but, in their correctly understood role as creditors to the banks, would become ‘deposit vigilantes’ and would help keep the banks in check. The banks would again have to communicate balance sheet strategy and risk management to the wider public in order to gain and maintain the public’s trust, and not just to a handful of highly specialized bureaucrats at the central bank or the state’s bank regulator. Banking would become less complex, more transparent and less leveraged. Conservative banking would again be a viable business model. And the wider public would begin to appreciate how dangerous the populist policies of cheap credit and naïve demands for ‘getting banks lending again’ ultimately are. The depositors are underwriting these policies and carry a lot of their risks.

 

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It’s official: Global economic policy now firmly in the hands of money cranks
Cyprus and the reality of banking: Deposit haircuts are both inevitable and the right thing to do

Comments

  1. Alan Wolan says

    Detlev,
    You have a real knack for expressing in plain English what a lot of us have been thinking for a long time but could quite put to words.
    Keep up the amazing work, we really appreciate your voice on these subjects.
    And please…write another book, we can only re-read the first one so many times!
    Alan, Los Angeles

  2. didier says

    Very true.
    It’s in my opinion the same for car manufatorers. In the seventies Mercedes was famous for quality. Today a Mercedes is not better build than another brand but all the regulation boxes are ticked.
    This situation makes me sooo angry. I’m from Belgium, Dexia country. When I see the new Belfius bosses on tv I think I could hurt them. I haven’t lost money but I’m so angry.

  3. Seth says

    The Cyprus ‘solution’, as apparently to be implemented, has impaired but not destroyed the popular perception that deposits below 100,000 euros are ‘insured’. A ‘tax’ on all accounts was initially suggested, but it was not adopted. When the dust has settled, will Joe Average remember that the EU authorities were originally willing to jettison the principle of deposit ‘insurance’ let alone act on that knowledge? Those with deposits of more than 100,000 euros are likely to become much more cautious because the implicit promise of insurance was abandoned and, arguably, as a group these people are better able to evaluate risk, but as far as individual (as opposed to business) depositors are concerned, they are likely to protect themselves in this new situation by (i) spreading their money across a number of banks (thereby retaining the deposit ‘insurance’) and (ii) selecting banks in countries where they think the government will be able to pay out the ‘insurance’ (if necessary, by printing money). If they do this, they do not have to study the balance sheets and business strategies of individual banks (as opposed to economies). The net effect may be for the banks in countries that satisfy the second criteria to have more depositors but the same overall deposit funding and therefore no incentive to ‘clean up their act’. As I have no business experience, I have no idea of the response of large businesses that have too much money to use this strategy or for whom such a strategy is impractical. Perhaps the response of this sub-group is the one that really matters.

  4. Snorri Godhi says

    Now i begin to understand what you have against deposit “insurance”. It reminds me of chapter 9 of The Road to Serfdom, where Hayek argues, if i remember correctly, that increased security for one social group can only come at the cost of decreased security for others; not to mention increased moral hazard.

    Anyway i suggest that deposit “insurance” should also be seen as a claim: a claim against the State, in case the bank collapses. The same holds for private-sector insurance, actually: insurance is a claim against the insurer, a claim which is worth something only as long as the insurer does not go bankrupt.

  5. says

    “They no longer reward prudent banks with inflows and punish overtly risky banks with the withdrawal of funds”—No, they do precisely the opposite.

    Look at the situation with Icesave its collapse. This small Icelandic bank offered the highest interest rates in the UK, so lots of depositors chose to move their accounts there. No thought was given to the possibility of default. I’d bet that not one in five of them had ever even heard of deposit insurance and the one that did figured, naively, that a tiny nation in the middle of the Atlantic could make good on that insurance.

    This Cypriot debacle has been a long overdue reminder to people that money deposited in a bank is a loanloan which the bank may or may not be able to make good on.

    Your call for a far more conservative banking system is fully warranted. A generation ago all banks were like this.

  6. Laird says

    I have been making this argument for a long time, but you have a better soapbox than I do!

    It isn’t really necessary to completely eliminate deposit insurance; I can see a benefit to having relatively small balances insured, as there is no real need to have all small depositors concerned over the health of their bank. I do think that the current US limit of $250,000 on interest-bearing accounts (and, as far as I can tell, unlimited on transaction accounts) is far too high. But the real problem is that it is government “insurance”. The sneer quotes are because this “insurance” is not provided on any sort of actuarial basis and so is improperly priced (and sized).

    Government insurance should be eliminated, and banks could obtain private insurance if they so choose and if they can get it. That would result in private insurers effectively “regulating” the banks to be sure that they are managed properly and intelligently. Banks could shop for insurers, so there would be some competition to ensure that the insurers don’t get carried away with their restrictions and also to keep premiums reasonable. Banks could decide what level of coverage they desire (and are willing to pay for) and their customers could decide how much insurance they desire and would choose a bank accordingly. And, most importantly, the price would be based on the actual riskiness of the bank (primarily its loan and investment portfolios), not the one-size-fits-all approach of the FDIC. Badly-managed and undercapitalized banks could not get insurance and so would likely have to close because they could not get deposits. (They would have to pay more for deposits, if any were available at all, and so would banks which chose to forgo insurance entirely.) Strong banks would pay less for their insurance and so would be more profitable (as well as safer for their depositors having balances above the insured limit). It’s a win-win for everyone except the bad banks (and, of course, the government bureaucrats).

    • David Goldstone says

      Or alternatively (and perhaps more likely) the depositers themselves could obtain default insurance. The insurance rates would then be an excellent indication of default risk.

    • Andy Harrison says

      Don’t forget that insuring subprime was a win-win situation for everyone… until it wasn’t. I’m thinking AIG. You can insure a house against fire and be safe in the knowledge that not every house will burn down at the same time. I’m no actuary but it’s fairly obvious that a bank run involves all of the depositors fleeing in a disorderly manner all at the same time. Same as if all the houses caught fire spontaneously. I should think premiums to cover such an eventuality would be pretty prohibitive if priced correctly. Of course AIG didn’t care and the employees of that company bet on something being so unlikely that it would never happen anyway. It did happen. It’s an uninsurable risk.

  7. says

    As this story rumbles on it would appear that the London branch of Liaki and a russian subsiduary were open and not putting any limits on withdrawals up until the capital controls were formally implemented. It is being reported that almost all of the deposits that were going to be trimmed have gone! True or not,the point is that the EU is still making loans of tens of billions of Euros to Cyprus regardless. The depositor haircuts were only going to be 5 to 6 billion anyway. How on earth are they going to repay these loans? Where is the money coming from in the first instance? I think we kind of know the answer already!

  8. David Goldstone says

    One of the often cited objections to the removal of deposit insurance (and of central bank liquidity support) is that it would result in bank collapses and depositers losing the money. To which the correct answer is that bank collapses are a feature not a bug. Free markets require the possibility of failure, without which there is no true capitalism.

  9. John Mark says

    I keep trying help people on Daily Telegraph blogs to realise such things as bank deposits belong to the banks, currency is being debased, but there seems little sign of interest or concern.

    Mention gold or silver and the silence is deafening.

    I guess it’s softening up time at the moment, a sort of speaking to the subconscious. Then, when our first bank closes its doors, we can write a little more explicitly.

  10. GRL says

    Finally, a rational discussion of the Cyprus situation.

    I agree, with one caveat: Since the government has promised depsoit insurance up to 100,000 Euros, it should keep that promise. Apart from that, let the shareholders and bondholders be wiped out, and then let the depositors take their losses.

    I hope the guy who is quoted as saying this will be a template for the rest of Europe turns out to be correct. Perhaps it will put the over-leveraged European banking system on a more sustainable path. (I do not mean to imply that U.S. Banks or the U.S. banking system are somehow superior, quite the contrary — after all, we ended up with TARP.)

  11. Lyonwiss says

    Deposit guarantee (not insurance, as government pays the claims and depositors do not pay premium) is a subsidy to the banks. This subsidy may or may not be justified on economic or moral grounds. But that is not the issue.

    The issue is democratic processes have be violated. Unelected bureaucrats have been allowed to change established rules and laws of the government, without democratic consultation.

    The long-established law is that depositors can lose their money only in the event of a windup of a bank. Remaining assets of bankcrupt entity are to be distributed to depositors first, then other creditors and finally shareholders. The fact that depositors are at-call lenders to the bank, therefore also creditors, does not imply they should be ranked like all other creditors.

    The key point is the bank must be allowed to fail before depositors can lose their money. Guaranteed deposits are paid by government to depositors. Unguaranteed depositors potentially suffer losses. What is unacceptable is that a failed bank is allowed to continue to operate by stealing from their depositors.

    In an even more bizarre document, “Memorandum of Understanding of Specific Economic Policy Conditionality” by the Troika, they proposed government deposit guarantees be given directly to the failing banks! The banking terrorists are holding a gun to the head of the government and extorting taxpayers money.

    • Lyonwiss says

      Sorry I made a wrong reference in my previous comment. The reference should be to the joint paper by FDIC and the Bank of England, “Resolving Globally Active, Systemically Important Financial Institutions” (or saving G-SIFI), where according to the European Union Recovery and Resolution Directive (RRD):

      “The proposed RRD also permits such an approach because it allows deposit guarantee scheme funds to be used to support the use of resolution tools, including bail-in, provided that
      the amount contributed does not exceed what the deposit guarantee scheme would have as a claimant in liquidation if it had made a payout to the insured depositors.”

      This clearly states that the money which would have been given to guaranteed deposits in liquidation can be annexed to save the G-SIFI.

  12. Andy Harrison says

    Did you read De Soto’s “Money, Bank Credit and Economic Cycles”. If you did I wonder why you would repeat such a fallacy:

    “This is not legal pedantry or just a matter of opinion but logical necessity that follows inescapably…”

    The only thing that follows inescapably from the irregular deposit contract is that the depositor is the owner and the banker is the custodian. It is no different to any other kind of warehouse, be it copper pipes or bags of flour. To deposit your property in a warehouse is to be able to call on it whenever you need it using your warehouse receipt. It is against nature that you could demand a thing instantly and not be the full owner. That’s the problem with this whole fractional reserve malarkey in the first place! The thing [money] is not lent to the banker it is deposited for safe keeping. It’s basically a bailment. If people want interest then they need to make term deposits and they will be unable to withdraw money then because it is loaned. That follows logically. You’ve repeated the same fallacy that got us here as far as I’m concerned. You also make some assumptions about what the public do and do not expect from a bank. I should think that most of the public think that there is real money in the bank. I speak to people about this subject all the time. Tonight someone even told me that the pound is backed by silver – it’s in the name “Sterling”. People’s expectations are important, and they expect the money to be there in the bank. Reasonable expectations are part and parcel of contract law. It’s simply not good enough to characterise property deposited for safe keeping as a loan. It makes no sense. You are correct it has developed like this over the years, but don’t tell me it’s logical, it most certainly is not.

  13. Laird says

    Andy Harrison, it’s clear that you do not understand the concept of bank deposits. They are *not* placed there for “safekeeping” or in a custodial capacity(that would be a safety deposit box, for which you pay a fee); they are loans to the bank on specified terms. The fact that you don’t (or won’t) understand that doesn’t change the reality of it.

    • Andy Harrison says

      I do understand. I know the legal position. I am arguing against the legal position as farce. You cannot be both deposit and loan at the same time. It’s against nature. Now the lawyers and “the law” may say different, but as a thinking man I care for neither lawyers nor the “law” that they offer.

    • Andy Harrison says

      I know you are supposed to pay a fee to have a deposit. I’m saying that the public doesn’t understand this and that is matter of policy – that the public should not understand this. It’s a fraud. It is a fraud upon society as a whole. It’s disgusting.

  14. John Richardson says

    ‘I am no friend of the EU and I feel uncomfortable finding myself in a position in which I have to defend their policies…’

    As you wrote on your previous posting, Sir.
    Well, don’t worry. I’m NOT from the government but I AM here to help……

    In the same posting you had also explained….

    ‘That is also what some of my libertarian friends don’t seem to get when they speak, as some of them did yesterday, of another incident of the ‘the state stealing from its citizens’ or of confiscating their property. As much sympathy as I usually have with these views, in this instance they are simply mistaken. If this were expropriation it would mean that the act of abstaining from this expropriation – of the expropriator simply doing nothing – would mean that the ‘victim’ keeps his property. But if the EU did nothing in this situation – “hands off”, laissez faire – it would mean that most depositors, including those under €100,000, got wiped out completely. The choice is not between keeping everything and paying a ‘levy’, but between paying a ‘levy’ and losing almost everything.

    Libertarians wrong EU right?????

    All our Spidey Senses should be tingling by now.

    Above you expose the union of corrupt government & corrupt bank’s co-interest in pretending to the host/customers/electorate that one can ‘make secure’ or really ever insure the other.
    You must be correct to suspect that; ‘…… the real purpose of these ‘safety nets’ has always been to provide cover for more generous bank credit expansion.’

    After reading your last two posting I knew you somehow must have put an ‘EU/fiat banking’ cart before a ‘sanity/reality’ horse.

    Surly, the reason that it is unfair to take money from people’s accounts in Cyprus is not that all deposits should always be safe from economic reality.

    Surly the reason it is immoral to take money from people’s accounts in Cyprus is not because these people failed to reflect on the absurdity of the little island’s modern banking industry.(Though as an aside; I would ask what would we suggest a Cypriot saver should have done with their money if they had concluded, after the requisite analysis, interest being paid seemed somewhat high when compared with international averages or the island’s GDP)

    No.
    The reason you are right to feel uncomfortable defending the EU and this policy is that the EU/fiat bankers are the BAD GUYS and taking folks cash to keep the Euro show on road stinks to high heven and it should do.

    Trust your instincts Mr S. not your intellectual appreciation of the technicalities of the situation.

    Your libertarian friends are correct but probably for the wrong reasons.

    Simply, the action in Cyprus has nothing whatsoever to do with ‘….a return to honesty, transparency and responsibility in banking..’ as you write above.

    Defending the actions, as you reluctantly do, is like running into a burning house shouting ‘put that cigarette out!’.

    Yes, cigarettes cause fires but that is not our problem (any more). Administering a dose of ‘micro reality’ to Cyprus whilst allowing the Russians to remove their Big Deposits and ignoring the ‘macro reality’ of a bankrupt western banking system and welfare state system and a partially insane European single Currency is not on. People with a tenth the economic education you have all know this. This is why they mumble about ‘stealing money’ and are wrong. Though they know the euro ‘elites’ with their dangerous dreams and lies are at the root of so many of our current (and coming!) woes.

    This is the reason why,

    ‘……many of the commentators who are now posing as defenders of the small saver are usually among the loudest proponents of exiting the euro’

    I would ask are they really the same people who call for,

    ‘…. issuing new and weaker currencies and using debasement to gain short-lived competitiveness’?

    Cos all the people I know (a small but fine crowd. Me included) calling to exit the Euro want to do so to wrest a modicum of power back for The People
    and away from dangerous deluded ‘elites’ and their weird power dreams.

    We see the wheels coming off their Great Project and we don’t wanna die in the riots.
    We don’t wanna be poor to create a United Europe.
    We want governing entities to be close enough to the People, and to be small enough so that we know who to hang when the political class do what they always do when removed from direct responsibility to us.
    That’s why we hate the Euro.

    Though,

    ‘…..issuing new and weaker currencies and using debasement to gain short-lived competitiveness….’

    Is a seductive and exciting dream to some, I honestly doubt it is a dream that animated your libertarian friends when they confused the technical reality of a bank deposit’s insecure nature with the grasping claw of the desperate EU.

    Finally,

    ‘All those who persistently argue against ‘austerity’ and for more stimulus, more debt, weaker currencies, higher inflation, do not care at all for savers.’

    No.
    They don’t.
    These are the kind of idiots who argued long and hard on their BBC, for us to join the fricking Euro in the first place. Now they pose as people who ‘care’ when their instinctive mental flights from reality are partly what has corrupted democratic politics in the West; leaving the door open for the Central Banks and Government and their ‘grow and prosperity’.

    Sheeeesh.

    Now I gotta start blogging to prevent the esteemed Schlichter himself sticking up for The Swine and their Great Agenda.

    It’s a good job I’m on holiday.

    Happy Easter!!!

    Of course, there are notable exceptions. In today’s Telegraph, Jeremy Warner does a good job explaining how costly the bailout of British banks has been – and still is – to British savers, not least via higher inflation, zero interest rates and endless quantitative easing. I also thought that Simon Nixon’s piece in the Wall Street Journal yesterday was informative and balanced. But they are the exception.

  15. Robert Gray says

    An excellent article. It seems to me that fractional reserve banking is just another form of QE(printing money). for every 10 Euros of honest profit deposited the bank can lend out several times that quantity in loans thus creating money.

  16. Carax says

    The death of democracy was marked long ago when Helmut Kohl shoved the euro down the throats of Germans without their consent. He recently admitted he was “dictatorial” in his approach, he knew a referendum at that time would have shot down any chances of a euro currency.

    • mike jones says

      0 short rates or close, 3% long rates or close. Numerous Bond funds disguised as financial loan centers paying 10% dividends with payout ratios over 100%. Shootings happening at random for no possible reason other than hoplessness. This is the USA picture of markets and life around the cities. Socialist values to extreme in politics mostly hidden. No real way to make money against super free money fed institutions unless you have the same rights as they do. (a printing press)
      I would say that the metals are the only place to hide if you want to save the remains of the strong dollar after it has been destroyed by free money leverage. Problem is that you have to buy metals with that free money and the masters in power do not want that.What country has the highest gold price right now in their currency. Major country. The dollar backed yen as far as I can see.134,646 as stands today for an ounce of gold in YEN.Amazing. I live in america on 2000 dollars a month. My bills are 1200 a month. What small amount of savings I have cannot be grown in real terms anywhere in the market.The risk is way to large. Where do you think I put it. Prices are rising for things around me with no end in sight. Even if Obama was to resign nothing truly would change anytime soon. When you spend billions to dig oil out of the ocean miles underwater where nothing can survive we have a problem. When you risk polluting your water tables searching for it on land you have a problem.When Canada our biggest oil importer is flooded with money from a growing socialist monarchy you have a problem.
      I see no way out but to give the USA the finger on monatary policies. I expect major crackdowns in the streets to become quite cumbersome and eventually the people behind this to start marching around in their nazi helmets eventually with automatic weapons they didn’t pay for. That’s what I expect not what I predict in my minds eye. I believe this time around the next college massacre from the militia or military will be the end of the usa. Not like in the sixties where people ignored it.The draft dodgers in the 60s were against the war. I expect the draft dodgers today (we don’t have a draft) will be in the war on their own turf. Just like Russia and Europe. Mass terrorist movement. Russia’s ruble went from par with the dollar to 30 some rubles for the dollar trying to satisfy the southern hemisphere.Using this much energy to produce very little in goods over time destroys the mind.
      The more I see around me the less I expect in the future. In the forties it was the exact opposite.And the rich were the ones who observed it.
      Most see these words a catastrophic. I see them as a desciption of the past.The future cannot see them at all.

  17. HG says

    Dear Detlev,

    “Depositors have been largely desensitized to the risks inherent in banking. They no longer reward prudent banks”

    From a austrian libertarian approach I can fully acknowledge that view. But today that is just plain nonsense. It is NOT the depositors fault or responsibility:
    1.) Today people&companies in Europe are forced by law to have their money in the bank and to pay by wired transfer.
    2.) Capital controls getting stricter and stricter especially on cash.
    3.) In Europe people are forced by the tax and social security system to participate in the retirement ponzi scheme (concerns both public&private fonds).
    4.) You will not get information on what you holding. Just an example: When you go to a bank, the bank is even completely uncapable to tell you, in what kind of vehicle you are actually saving. Try it yourself, go to different german banks (Volksbank, Sparkasse, Postbank…) and get even the most simple “Sparbuch” and try to get information on what you are holding in your hand. You wouldnt get answers.
    5.) There is no rule-of-law in which order defaults or on what limits haircuts will be taken, it is the free will of politicians, changing every time.

    So whenever I read that stuff “get the depositors, it’s their responsibility” in austrian circles these days, I really wonder where they get those ideas.
    Please dont take that personal, just saying.
    Gruß, HG

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