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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