I've argued vigorously against deposit insurance ever since 2007. A bank deposit is a loan to a bank. If you loan money to a chip shop and it goes bust, you'll own a chip shop. If you loan money to a bank and it goes bust, you should own a bank. Deposit insurance of fractional reserve banks is deeply misconceived – insuring capital does not prevent bank runs (its insuring liquidity that does that) and it's very difficult, once one starts insuring deposits, not to go the full hog into bailing banks out. If you want to save money in a safe, insured bank, you should put it in a storage deposit account (like an old savings bank), not a fractional reserve deposit.
So, with the Cypriot scheme to impose losses on depositors, I should be dancing for joy, no? Well, in fact, no. Why not? Here's three reasons:
- They didn't impose losses on bank bondholders. Of course, there were only €2bn of bonds to get in Cypriot banks, which wasn't nearly enough, so they would have had to impose losses on some depositors even if they had imposed losses on bondholders, but that's not a reason not to impose losses on bank bondholders. Imposing losses on depositors but sparing bondholders is just wrong.
- The depositor participation proposed takes the form of a tax, imposed on all bank deposits in Cyprus (whether in bust or good banks – indeed whether in Cypriot or foreign banks) in exchange for equity in Cypriot banks (so if you have deposits in a Barclays branch in Cyprus you will lose some percent but get shares in some local bust bank – super). That eliminates a key economic function of depositor exposure to risk of loss – the reward for putting one's money in a good as opposed to a bad bank. It's wrong for the state to bail out depositors in bad banks to keep the rich rich despite their errors. But it's just as wrong for the state to haircut depositors in good banks to help keep the regime afloat. The form depositor participation should have taken was for bust banks to be put into administration, then if the bank were liquidated, depositors would be paid out their share. Instead, there has been a pre-announced date at which the haircut will occur, with a Parliamentary vote in between, because it's a tax measure, and anyone that can withdraw her money before then does not get taxed so all the banks in Cyprus, whether bust or not, have to be shut down (closing off the payments system, credit, etc.) until the vote passes. The technical term for that arrangement is "bonkers".
- Of course, the reason the bailout has taken the form of a tax is to get around the European Union's daft €100,000 deposit insurance threshold. If banks had been put into administration, the insurance would have had to pay out. That limit clearly is too high to be credible. Unless your name is "Simon Cowell", €100,000 in cash is not a "small deposit". If the limit had been €10,000 there would never have been any question of "taxing" small depositors. But, daft or not, that was the promise made to depositors and it's clearly not worth much. That is, of course, merely the latest in a long line of promises made by Eurozone authorities that have been broken. The monies lent to Greece in early bailouts were promised not to be senior to the government bonds held by private investors. That promise was broken. The first Greek bondholder haircut was promised to be final. That promise was broken. Now the deposit insurance threshold is not being respected. Policymakers promise that Cyprus is unique and there is no possibility of similar deposit taxes being imposed in Portugal, Spain or Italy. Believe that?
As I write, it appears that the Cypriot deal has unravelled, as Cypriot Parliamentarians refuse to vote in favour of it. Chaos reigns.
The principle of depositor participation in bank failures is entirely sound. I debated the principle yesterday on PM with Louise Cooper (19min on). She was scandalised at the idea small depositors might be exposed to loss, despite the fact that the UK banking sector somehow survived with no deposit insurance whatever until 1979 and with only £2,000 until 2007. If she is correct that depositors cannot understand fractional reserve bank balance sheet – and she may well be – the solution is fairly simple: don't deposit your money in a fractional reserve bank. No-one thinks the solution to the complexity of complex derivatives is for the government to insure them so that ordinary people can invest in them. Why should a fractional reserve bank be different? If your answer is: because people need somewhere to store their money, then I have already answered that as the UK financial system answered that long ago – they should store their money in savings banks, not fractional reserve banks. (A "savings bank" or a "storage deposit" is 100% backed by government bonds, cash or gold, and could harmlessly be 100% insured without limit by the state.) There is no economic need or justification for insuring fractional reserve deposits at all. They are insured in the UK only by an accident of fate.
I fear that the clumsy way depositor participation has been introduced will discredit the concept. Bank creditors should not be haircut by taxes or inflation or other such schemes. Bust banks should simply be placed into administration if they have seriously inadequate capital, then their debts should be converted into equity or they should be liquidated, as appropriate. Crazy political schemes, designed to serve political purposes, are steadily and continuously undermining the economic and ethical foundations of what little remains of private capitalism.