Cyprus and the reality of banking: deposit haircuts are both inevitable and the right thing to do

I, too, was shocked Monday morning. Not so much by the news that depositors at Cypriot banks would face a haircut, or a ‘levy’ or a ‘tax’, on their deposits as a contribution to yet another Eurozone bailout package funded by taxpayers in other counties but by the reaction in the press.

Here was, according to the majority of the international commentariat, yet another example of the ineptitude or outright meanspiritedness of the Eurozone policy elite, another example of imposing needless and counterproductive hardship and brutal ‘austerity’ on innocent citizens in small and troubled countries. The Daily Telegraph on its front page spoke in usual hyperbole of a ‘EU raid on savings’ and, naturally, of another ‘threat to the recovery’. What agitated most commentators was that the ‘sanctity’ of deposit insurance had been carelessly violated as even deposits of less than €100,000 were, at first at least, supposed to be subjected to a reduced haircut as well. Those types of deposits are supposed to enjoy a ‘guarantee’ that magically shields them from the harsh reality of bankrupt banks and bankrupt states. Undermining this ‘guarantee’ could have wide-reaching consequences beyond tiny Cyprus as it has the potential to undermine the trust in banking systems in Greece, Spain and Portugal.

I agree that this move is risky. The international banking system is highly levered and in large parts has been teetering on the brink of disaster for many years. Anything that affects depositors can have grave consequences. But given the state of affairs, any meaningful attempt to deal with the banking systems’ problems must inevitably entail risks. The questions are the following: are the right type of risks being taken? And what would the alternative be?

Banking is a risky business because banks are highly leveraged enterprises. (Sorry to break that news to you.) In a fractional-reserve banking system ‘deposits’ are not deposits (i.e. contracts for safe-keeping) but loans to banks and thus loans to highly leveraged businesses.

Most people in developed countries have become used to not worrying about the health of individual banks. They have, over the course of decades, been conditioned to believe that all banks are regulated by the state and ultimately protected by the state. – Yes, but only so that the banks can take even more risks and become even more leveraged. State ‘protection’ has now created a banking monster that is swallowing up the resources of the state itself. And this can hardly come as a surprise in early 2013!

The naïve belief that bank deposits are always ‘money good’ because they are backed by the state and the state, after all, is an endless cornucopia, was maybe understandable, or at least excusable, until about 2008, when then Prime Minister of Ireland, Brian Cowen, in the middle of the Irish banking crisis, had the genius idea to simply declare a state guarantee for all deposits at Irish banks. Hey, problem solved! Obviously, Cowen didn’t do the math and didn’t realize how big that guarantee was going to be. Well, he was found out by the markets – and Ireland, the country, went bankrupt.

After Lehman, after Ireland and Iceland, and after Greece, I think you must have lived in a cave for the past 5 years to really think that banks are safe because they are guaranteed by their governments. Come on! Please get real.

Excuse me but my sympathies for Cypriot depositors is somewhat limited. If you are a depositor in a Cypriot bank, whether of deposits of more or less than €100,000, who did you think was guaranteeing your deposit? The Blue Fairy? Did you really think that in such a small place with such a bizarrely bloated banking system – one that for years and, by now, very publicly had been investing in Greek government bonds! – your government had the resources to protect all depositors? The bailout of Cyprus’ two largest banks will cost the equivalent of 60% of GDP! And after what happened in Greece, did you really think that the Germans were willing to cover the whole bill?

I am a free market guy. I am in favor of laissez faire so I always like to see placards that read “Hands off”. One could see such placards at demonstrations in Cyprus on Monday: “Hands off Cyprus”. That is great. But be careful what you wish for. A proper hands-off policy means letting the chips fall where they may. That would certainly mean no bailout and thus total collapse of the Cypriot banking system and the Cypriot economy. Don’t forget that Cyprus and its banks and its depositors are still being bailed out with other people’s money here.

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.

Some commentators will object here and say that, for the sake of a more cheerful public sentiment and for the sake of the nascent recovery, the bailout should be more generous and protect more Cypriots to a larger degree. But that would mean either more expropriation (and now the word is indeed appropriate) of taxpayers in Nordic countries, or more money-printing by the ECB. And this is where many commentators are either short-sighted or indeed hypocritical.

Using the printing press to cover any excess committed by banks and governments, no matter how outrageous, must mean inflation and this certainly hurts all savers, including those with savings of less than €100,000. I found it particularly galling that many of the commentators who are now posing as defenders of the small saver are usually among the loudest proponents of exiting the euro, issuing new and weaker currencies and using debasement to gain short-lived competitiveness – all measures that defraud the domestic saver. All those who persistently argue against ‘austerity’ and for more stimulus, more debt, weaker currencies, higher inflation, do not care at all for savers. As Keynes famously suggested, they want to kill the rentier class, whether the rentiers are big or small. And now they claim to be the advocates of savers?

Of course, there are notable exceptions. In the Telegraph, Jeremy Warner did 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 was informative and balanced. But they are the exception.

I am no friend of the EU and I feel uncomfortable finding myself in a position in which I have to defend their policies but I feel that those elements for which the EU gets most viciously attacked in the media – ‘austerity’, letting Greece default, at least partially, bailing in depositors – are most sensible to me as these policies are, in principle at least, based on an acknowledgement of the underlying problems and as they do not seek near-term comfort in the deceptive and damaging policies of endless fiscal transfers and money-printing.

This article was previously published at DetlevSchlichter.com.

28 Comments

  • mrg says:

    Surprised by this article. I normally find myself agreeing with everything you write, but I must disagree here …

    “The naïve belief that bank deposits are always ‘money good’ because they are backed by the state …”

    I’d prefer the deposit insurance didn’t exist, but it does, and where the state controls the printing press, it’s not unreasonable to expect this promise to be met, in extremis, by money printing.

    In Cyprus savers probably should have been a bit more wary, knowing that their government had relinquished control of the printing press, but there do seem to be strange disparities between the treatment of the Cypriots and the treatment of other citizens of Club Med.

    Deposit insurance, if it exists in the Eurozone, should be provided by the ECB.

    The rule of law should not be discarded lightly, even when it involves laws that we don’t like.

    • Gary says:

      How can a market clear properly without ALL stakeholders at risk getting rewarded for success and punished for failure ? Caveat Emptor.

      Deposit insurance has no place in a free market , and in any case is always insufficient in a crisis.

      • Gary says:

        I meant to say “taxpayer funded deposit insurance”. Private deposit insurance is not a problem, the premiums on which could also be used as an instrument for rating the banks.

    • waramess says:

      Hard to understand why you should think that becausse the state controls the printing press they should be responsible for the safety of bank deposits.

      As printing money does no more than devalue the worth of existing money in circulation such a government guarantee will effectively result in the “poor” suppporting the deposits of the “rich”.

      Far better a system that relies on commercial insurance where the sum total premium of depositors might protect the deposits of the few.

  • CaptainSkin says:

    If you’ve still got money in any high street bank, you seriously need your head looked at…

  • TS says:

    I’m with mrg- well said, and as for Mr Schlichter, you are missing the point- I’m speaking of the loss of trust. Its not enough for working people to worry about their bank failing, the purchasing power of their deposits eroding away through inflation, now they lay awake at night worried that their government will steal what’s left and they’ll have no say in the matter, their accounts frozen by decree: totally intolerable. Fiat currency- whatever the flavor, is a scam pure and simple. People are waking up to this fact quickly. It’s the loss of trust and without trust markets simply cannot function.

  • Craig says:

    “Deposit insurance, if it exists in the Eurozone, should be provided by the ECB.”

    Heh. Just like in the U.S. where everyone thinks there’s a giant insurance fund somewhere to make depositors whole again. Of course, such a fund doesn’t exist. If a bank is allowed to fail, the “insurance” payments are printed on Bernanke’s laser-jet.

    Excellent article. First one I’ve read anywhere that makes sense.

    • mrg says:

      You’re right that ‘deposit insurance’ is something of a misnomer. It doesn’t bear much resemblance to ordinary insurance.

      ‘Deposit guarantee’ would be a better name.

      My point about the rule of law stands. Scaling back the welfare state is one thing – most people expect it to happen – but failing to honour guarantees on savings is quite another.

      Certainly the normal rules of bankruptcy should have applied here.

  • Mr Ed says:

    The government guarantees your savings, but seizes them to pay for your guarantee…

  • mrg says:

    “Using the printing press to cover any excess committed by banks and governments, no matter how outrageous, must mean inflation and this certainly hurts all savers, including those with savings of less than €100,000”.

    Somebody help me with this one.

    If you have 100k in the bank, and the government has to double the money supply in order to honour the guarantee, you’re effectively left with 50k, which is surely better than nothing.

    You can argue that the guarantee wasn’t really honoured – that effectively you faced a 50% haircut – but that’s still better than losing everything.

    What am I missing?

    • Hi mrg,

      To save Cypriot banks it would not be necessary for depositors to “lose everything” as you put it. Just plucking numbers out of thin air, if there was no IMF or ECB assistance, depositors might have lost about half their money. So that comes to much the same as your “100k / 50k” scenario.

  • J Cuttance says:

    Neither insurance nor guarantees are appropriate for outcomes over which the financial institution has so much control. New Zealand’s absurd guarantee fell at its first hurdle when a guaranteed finance company began taking even greater risks to get out of trouble. Let banks fail and let more responsible banks fill the vacuum.

  • Paul Marks says:

    The government has, repeatedly, pledged that bank accounts are safe.

    “Haircuts” mean this is NOT TRUE – and, once the principle is conceded, there is no logical reason why the “haircut” should not be 100%.

    Therefore (if this is to be the new world) everyone should take as much as they can out of the banks – NOW.

  • Nice article by Detlev Schlichter, but it had just one fault. He didn’t suggest a solution to Cyprus type chaos. And that’s a pity because there is actually a solution that stems almost automatically from the Cobden Centre’s opposition to fractional reserve banking. That’s an opposition I agree with. I’ll explain.

    The basic alternative to fractional reserve is full reserve: that’s a system under which commercial banks cannot create money. The only money is central bank money or “monetary base”. Those in favour of the gold standard want a gold monetary base. Personally I’m happy with a fiat monetary base.

    But in either case, commercial banks cannot “lend money into existence” as the saying goes. And to stop that money creation, if a depositor wants £X of their money loaned on or invested by their bank, the depositor cannot be allowed access to the £X at the same time as the lender has access to it: else £X has been turned into £2X.

    For example in Laurence Kotlikoff’s version of full reserve, if a depositor wants £X lending on, the depositor would then be given £X worth of unit trust units. The depositor would no longer hold money. The depositor could choose what they wanted their money put into, in the same way as people have chosen what type of unit trust to put money into ever since unit trusts were invent ed.

    The net result is that if the loans or investments do badly, its impossible for the bank to fail. All that happens is that the unit trusts lose value.

    As to money that depositors want to be 100% safe and instant access, that is not invested or loaned on at all under full reserve. The money is just lodged at the central bank.

    • Gary says:

      I agree that is the answer , Ralph. But there is no need to even have govt enforce 100% reserve banking. In a free market with unlimited liability on all risk takers in a bank, including the depositors, fractional reserve banks will be arbitraged out of existence very quickly. By investor choice.

      The same is true for unsound money.

      • That’s certainly an idea – which has given me something to think about. But I think nevertheless that everyone is entitled to a 100% safe bank account, and only the state can guarantee that. So the state must play some sort of role.

        Of course it might sound a joke to say the state can guarantee anyone’s bank account in view of the current shambles in Cyprus. But remember that under full reserve, the state does NOT GUARANTEE accounts where the relevant money is loaned on. And that’s where the losses arise. Had that system been in operation in Cyprus, depositors who were lending to Greece via Cypriot banks would have lost out big time. But depositors who opted for 100% safety when first lodging their money would have been safe.

  • Paul Marks says:

    Mr Musgrave – there is no “solution” to the Cyprus situation.

    Cyprus itself is an unsustainable Welfare State – and the (credit bubble) banks in Cyprus have lent vast sums of money, to the bankrupt Greek government (and so on).

    There is no solution to this – to ask for a solution is like asking for the square root of minus one.

    There can be no “solution” – other than de facto bankruptcy.

    • But bankruptcy is itself a solution. I.e. it’s a solution which involves saying to creditors (i.e. depositors) “you’re getting e.g. 60p in the £, and that’s it. Tough luck”. Plus the shareholders ought to be wiped out. It’s then up to the administrator to sell Cyprus banks to the highest bidder. If the highest bidder offers 1p, then so be it.

      In short, full reserve (when a bank is in trouble) is a sort of slow motion bankruptcy. That’s better than a sudden panic of the sort we are currently witnessing.

      • Mr Ed says:

        The situation for Cyprus is not unlike that of the passengers on a wooden ship, wrecked on a treeless desert island. If you burn the boat, there is no wood, it won’t go on as before, but it might make some rafts, or shelter.

        If you lift the cover and look at the Cypriot banks, there is less money there than the liabilities.

        At present everyone wants to be the first to take a plank or two from the ship to build a hut, and if that happens only the fastest through the door could possibly be satisfied. The reality is that the ship is wrecked, it’s now a question of making rafts or burning the timber.

  • john in cheshire says:

    Interesting article but I can’t agree with the conclusions. If we were told that our money in our bank accounts is subject to arbitrary theft then perhaps there would be some legitimacy in the assertions that we should lie back and be shafted. But when the promise is that our money is safe, at least up to the £85k limit, we should be able to rely on that promise. Now, if the rules have changed then the BofE or the Treasury or whoever makes the rules should tell us so that we can make alternative arrangements. I’ve written to my MP, who happens to be Mr Osborne, for some assurance that my money isn’t going to be stolen. If that assurance isn’t forthcoming, or if it is but it’s a lie, then I need to be told because as soon as I can, I shall put it out of reach of the government, the BofE, the EU or anyone else who thinks they are entitle to steal off me with impunity. I may not be Russian KGB but I expect the same level of deference if not fear as they are afforded.

    • Gary says:

      Govt lies all the time. Deposit assurances are another lie, there is not enough money in the fund to cover potential liabilities. The outrage is not that govt lies, the outrage is that anyone believes the lies.

  • Paul King says:

    I think what is being missed here is that when you put your money in a bank, you have lent it to them and you become an unsecured creditor. The money is not yours, it is a liability of the bank.

    On a purely technical basis you could argue about the pecking order of the creditors and why the depositors at are the very bottom. The bailouts have never been about protecting the people, it’s always and everywhere been about preventing the creditors of the insolvent banks from taking a loss. That is the crime.

    But in general, if you lend your money to a bank and the bank goes bust, you lose your money. The problem is that most depositors have no idea that is the case. The fact they get paid interest and in Britain at least, receive free banking facilities, is the obvious proof but still, no-one thinks along those lines. You need only listen to the current discussion in the media and even in the alternative media by people who are supposed to understand our monetary system but still consider deposits as belonging to them. That ended in 1811 (Carr vs Carr).

    So, how do we resolve this system? I despise this slow grind, I’d rather we took the pain now. I despise deposit insurance as the horrific enabler of blanket moral hazard, apathy and ignorance. But I also feel that the people have been cheated.

    They go to work, save, get paid interest that is less than inflation and genuinely think the money in the bank is their own. They enable the banks to engage in fractional lending which hurts their interests. They get taxed on most of what they earn and they are forced to comply with their own robbery via legal tender laws. People thinking of their own survival will always vote to take from someone else. Because of that fact. the system has to go the way of default by inflation. If a true deflation occurred, only pieces of real paper would become valuable and no government will allow rioting in the streets when all they need to do is print some pieces of paper and deliver them where needed. Any government who tries to default honestly will be removed very quickly.

    So… in trying to find a solution that is possible, given where we are and the level of ignorance of the population I think there is only one which resets the system and hurts the people the least. I would rather we let all the banks fail and the whole system collapse, default on the debt and get rid of the central bank. We get rid of deposit insurance, capital gains tax and legal tender laws. The only tax I would even consider would be a consumption tax. Then we honour the previous deposit insurance agreed to individuals – that is the only money that will be conjured out of thin air. Then we see where the value settles at. It think it would be the only way we could ever get the people to agree.

    • Paul King says:

      I just wanted to add…

      Those with the least would be protected and those with larger fortunes are likely to be more diversified and perhaps but not always have less cause to be ignorant.

      It’s a horrible situation. I just think default would turn nasty real quick, hyperinflation is more likely and ultimately worse. Perhaps my situation, still extraordinarily painful, could avoid both. And at least from then on, the market would be regulated by failure.

      The really hard sell is shrinking government to an affordable level when so many are dependent.

      What a mess!

      • Paul King says:

        I’m not sure I made my point well…

        A lot of media outlets both mainstream and alternative media are saying it’s theft. That makes the average person see it as a worrying thing, but less likely to affect them because it’s a one-off crime that may or may not happen and is unlikely to happen in their own country.

        What they should be saying is… “it is not theft at all, sure… the deposit insurance hasn’t been honoured but don’t you realise that money in a bank account is not legally yours – maybe you should go away and have a good think about that and what you can do about it?”

        This theft line is, in a perverse way, protecting the system.

        • Gary says:

          You made your point very well. A sensible clarification of the true nature of deposits at risk. It is so ironic that people who profess to be sound money adherents get so exercised when they find out that deposits are not 100% safe.

  • Paul King says:

    Detlev… I have an interesting question about this Cyprus situation you may be able to answer.

    I have no idea what the ratio requirements are in Cyprus – they may not even have any like us in the UK. But’s let’s imagine the banks in Cyprus are fully loaned up and have a fractional reserve ratio of 10%. Wouldn’t taking 10% of the deposits collapse the bank. Surely the 10% “tax” or “levy” is going to end up coming from the deposits they actually have. Wouldn’t the bank immediately have to shrink it’s loan book to almost nothing to be compliant with the reserve ratio, once 10% of those “deposits” have been taken?

  • Steven Farrall says:

    If the depositors are lenders to the bank, why not swap the haircut for the equivalent value of bank stock? A debt for equity swap. This would move the liability of deposits (loans) to capital. Whilst the Cypriots are at that why not impose the same solution on all Cypriot bank bond holders. These (I understand) are predominantly the ECB and the Germans. Wonder why that’s not being discussed…?

  • Bodge says:

    It should quite simply be as illegal any other “form of theft” to take peoples money. If you set a “legal precedent” by stealing just one pound or euro then it can escalate very quickly and become a grand fraud of anyones cash, to call it legal is a joke. If you want to save the euro (who in their right mind would want to do such an utterly stupid thing) but if you want to save the money system then have a system where any person can only “physically own” say 50 million maximum the rest of what you have would be held by the treasury because lets face it unless your one of these very sad mentally ill 500,000 dollar a night hotel guests you do not need that much money to simply live but its the super rich who are being left alone as the little man suffers the theft of his meagre earnings. There is a grand fraud being carried out and Cyprus is only the taster. You want to create a revolution then keep going and you will.

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