Forbes: The Cyprus Bank Bailout Could Be A Disastrous Precedent: They're Reneging On Government Deposit Insurance

Tim Worstall

There’s a little detail in the just announced bailout of the Cypriot banks (and Cypriot economy as a whole) that could be setting an entirely disastrous precedent for the entire European banking system. Please note the “could be” here, it depends upon how people react next.

That Cyprus and its banks need bailing out is beyond doubt. The banking sector is absolutely vast as compared to the size of the economy (largely as a result of a couple of decades of use as a secure location for Russian deposits) and the banks are indeed bust. Largely because they were heavily invested in Greek Government bonds which then, as we all know, suffered two substantial haircuts.

So, something needed to be done. And something has been done. More money is being sent in to recapitalise the banks, Cypriot loans are being rescheduled, the government will sell off assets to help plug the gap and so on. However, there is this one further detail that could have seriously bad effects:

Euro-area finance ministers agreed to an unprecedented tax on Cypriot bank deposits as officials unveiled a 10 billion-euro ($13 billion) rescue plan for the country, the fifth since Europe’s debt crisis broke out in 2009.

Cyprus will impose a levy of 6.75 percent on deposits of less than 100,000 euros — the ceiling for European Union account insurance — and 9.9 percent above that.

There’s nothing particularly bad about making depositors carry some of the load of a bank failure. Indeed, it has something to recommend it: if it happens occasionally then people will take more care over where they put their money and what the banks do with it.

However, there’s a very great difference between allowing depositors without government insurance to take losses and actually reneging on the previously promised government insurance. And it’s that second that they’re actually doing here. Here’s the description of the Cypriot government depositinsurance scheme:

Participation in the DPS is compulsory for all banks authorised by the Central Bank of Cyprus, i.e. banks incorporated in the Republic of Cyprus, including their branches in other countries, and the Cyprus branches of foreign banks, incorporated outside the Republic of Cyprus or the Member-States of the European Union. The DPS does not cover deposits of branches of banks established in European Union Member States. These deposits are covered by the corresponding deposit protection scheme established in the country of incorporation.

The DPS is activated in the event a decision is reached that a member bank is unable to repay its deposits, or as a result of a Court’s order for the winding-up of a member bank. Where a bank is unable to pay its deposits, the relevant decision is adopted by the Central Bank of Cyprus or, where a member bank is incorporated in a country outside the Republic of Cyprus, by the competent supervisory authority of the country of incorporation.

The maximum level of compensation, per depositor, per bank, is €100.000.

Note that last number. Under the system until yesterday all depositors in Cypriot banks were insured up to the value of €100,000 with any one bank. Today that solemn and governmental promise has been shown to be false. And not even the European Union nor the European Central Bank are going to make them stick to it. Indeed, very much the other way around. The EU and ECB are insisting that the Cyprus authorities breach this deposit insurance provision.

As I say, there’s nothing wrong with making uninsured depositors take some of the pain. Certainly nothing at all wrong with making those with large deposits take a haircut. The problem is when government has said “we’ll insure this” and when push comes to shove they say “err, no, we won’t”. And the problem with this is that it makes all future EU deposit insurance worth that much less.

Think through why we have deposit insurance? Banks, simply because of fractional reserve lending, are vulnerable to bank runs. If all the depositors turn up at the same time looking for their money back they cannot have it: it’s out in the loans to businesses and mortgages to consumers. This is a known fragility of the system. The only possible solutions are either to have full reserve banking (a bad idea for other reasons) or to have deposit insurance. In that insurance the government stops bank runs stone dead. By promising that depositors (up to some level) cannot lose money. Thus a run does not form and become self-fulfilling.

The point isn’t to make the depositors whole: it’s to stop a bank run forming in the first place. But, what if the government then reneges on a promise to insure depositors? Then the insurance isn’t going to stop bank runs, is it?

How important this is will clearly depend on how many people take note of it. Imagine that, say, the Italian banking system gets into trouble. If we all knew, or all depositors in Italian banks knew, that deposit insurance was inviolable then there might be a way to deal with a troubled Italian banking system. But if word gets around that, whatever people have actually said, deposit insurance isn’t inviolable, that if there are serious problems then government will not live up to their promises (or perhaps, that the EU will not allow them to do so) then what use is the insurance in stopping bank runs? Why won’t all the money flee to Germany thus creating that very bank run everyone is trying to avoid?

Perhaps I am over-emphasising this. But it looks like an extremely dangerous decision for the future to me. Even when Iceland and all its banks went bankrupt the Icelandic government did keep its promises under the deposit insurance scheme that it had. And breaching that principle just seems to be obviating the whole point of having deposit insurance in the first place.

I certainly wouldn’t want to be a central banker trying to deal with a banking liquidity crisis now that it’s been shown that government promises aren’t worth the paper they’re written on, that’s for sure.

It really does strike me as an extraordinary decision, one that will have unpredictable long-term effects.

more at http://www.forbes.com/sites/timworstall/2013/03/16/the-cyprus-bank-bailout-could-be-a-disastrous-precedent-theyre-reneging-on-government-deposit-insurance/