Economics

Good riddance to deposit ‘insurance’

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.

This article was previously published at DetlevSchlichter.com.

8 comments to Good riddance to deposit ‘insurance’

  • mrg

    “in former times, sturdier and more honest, no rational person claimed that the depositors were unfairly ‘bailed in’ or were the victims of ‘theft’.”

    Ordinary decent citizens of modest means have little choice but to play the game as laid out by the government.

    Everyone who holds British pounds understands (or should understand) the rules of the game. Those rules currently include:

    * government control of the monetary base (licence to print money)
    * fractional reserve banking
    * deposit guarantees

    It is perfectly rational under these rules to deposit up to the government-guaranteed amount. If your guaranteed deposit is seized, it is perfectly rational to consider this theft.

    Let me be clear: I don’t think governments should control the money supply, and I fully agree that deposit guarantees are a bad idea. But to renege on existing deposit guarantees is to forsake the rule of law.

    Do I believe that all government promises should be honoured, no matter how unreasonable? No. But of all the promises to break, deposit guarantees should be the last.

    As for fractional reserve banking, it may be dangerous, but it isn’t inherently fraudulent, and I don’t think it could be legitimately forbidden by a libertarian government. Once legal tender laws, deposit guarantees, and central banking have been abolished, if people still want to trust notes issued by CasinoBank, that’s their business.

    • Phil G

      mrg,

      I agree with every point you’ve made with the exception of:
      “It is perfectly rational under these rules to deposit up to the government-guaranteed amount.”

      I think this is only true if you A: trust the government’s intentions and, B: trust the government’s capability, to honour this promise should the need ever arrise.

      So for your average non-thinking sheep, yes it is rational, albeit naive. But if you have a better understanding of the real situation (like yourself, and most of the readers of this blog I suspect), then no it is not rational.

      My point is, in the UK, the existence and promotion of the FSCS Deposit Protection Scheme is not for the benefit of any individual depositor. It exists because the government and the banks are so desperate for depositers to feel comfortable leaving their money in the bank, due to the dire consequences if this were not the case (so I suppose you could argue that this indirectly protects all depositors as a whole, but not in the way that most people perceive it to).

      I cannot imagine a scenario where this promise could ever be honoured, simply because any event that is catastrophic enough to fully bring down a UK bank, will surely result in bringing down ALL the UK banks either simultaneously or in quick succession. The FSCS scheme will prove useless in such a situation.

      I’m a newbie to commenting on this blog, so I hope I’m not getting the tone wrong! Forgive me if I am, I don’t mean to offend. I strongly suspect I’m not disagreeing with the point you were making, just expanding upon it in a way that you had not chosen to.

      • mrg

        Hi Phil,

        No worries with the tone. Very civil even by our standards :-)

        ISTM that if the government has the keys to the printing press, there’s no question about B – they’re perfectly *capable* of honouring the promise. Such action is not without costs, of course.

        Your question about government intentions is a good one. Starting with Northern Rock, the government could have kept quite strictly to protecting depositors in line with their promises. Instead, they saw fit to bail out the banks at taxpayers’ expense.

    • Mrg,

      Contrary to the claim in your last paragraph, I suggest that fractional reserve actually is fraudulent – at least in the following sense.

      An FR bank, 1, accepts deposits, 2 lends on that money in ways that are not 100% safe, and 3, promises to return the exact sum originally lodged to the depositor. That works nine years out of ten, but it’s blindingly obvious from the history of banking that that strategy goes wrong every now and then. The fact is that banks fail.

      That fraudulent element would be removed if banks openly said to depositors something like: “If you want interest, we’ll invest your money, but you take a hair cut if the investment goes wrong. Alternatively if you want near 100% safety, we’ll do nothing the slightest bit risky with your money: e.g. lodge it at the central bank where it will earn no interest.”

      • mrg

        Ralph,

        It’s true that a large portion of the public don’t seem to grasp the legal reality. The Cobden Centre’s survey from 2010 makes that clear:

        http://www.cobdencentre.org/2010/06/public-attitudes-to-banking/

        Even so, the very existence of deposit guarantees should be enough to make clear that our banking system is inherently risky. The dullest citizen should be able to appreciate that their deposits are insured only up to the specified limit.

        Nobody can be aware of deposit guarantees and yet think that banks are otherwise risk-free.

        I’d favour some tidying up of the terminology, and some very explicit statements in large print, but once that’s done I don’t think there’s any question of fraud.

        If the contract for CasinoBank states that (in exchange for a very attractive rate of interest) a coin toss determines whether you get your money when demanded, that’s fair enough. People can understand the risks, and willingly take them.

        There’s no need to go so far as mandating 100% reserves. The problem with our current system is that everyone is more or less forced to use the same government-issued currency. If each bank issued its own notes, the free market would apply an appropriate discount to notes issued by CasinoBank.

  • JimT

    I have to disagree with the entire premiss here. Call deposits are a straight storage function. Until the 1970s they never gained interest, they entailed a monthly charge. Further, fractional reserve banking isn’t the issue. All bank lending is fractionally reserved. If it weren’t loans couldn’t be made at all. The issue is that call money has a maturity of zero days and any loan has a longer maturity. That duration mismatch will always have a loan against call money eventually default. You are lending long and borrowing short (zero). That must blow up eventually.

  • Paul Marks

    The best book on the history of money and banking is “Money, Bank Credit And Economic Cycles”. One of the points it makes is that the word “deposit” is misleading (widly so).

    To a native English speaker the word “deposit” is like “grain deposit” (at a silo) – the thing that “deposited” is PHYSICALLY THERE (at the place where it was “deposited”).

    I agree with D.S. that no bank could pay interest on such a deposit – indeed one would have to PAY THE BANK to look after the money.

    The best way out of this would be to drop the (wildly misleading) word “deposit” .

    Banks would advertise for people to LEND THEM MONEY (no talk of “deposites”).

    Also a bank balance sheet and books would be laid out in a rational and honest way – wildly differently from how they are laid out now.

    For example, money loaned out would be shown as money loaned out (not “credited to the account of”) and the only money shown as being in the bank would be PHYSICAL CASH in the vaults.

    “But then the books of a modern bank would like the books of old fashioned money lender”.

    Yes – exactly.

    As for “Deposit Insurance”.

    Sadly the practice is not in retreat – it is SPREADING.

    In Cypus a vast number of business enterprises are being cold blooded destroyed.

    How?

    Because a business that had money in one of the two main banks is going to lose half (or all?) of this money.

    Vast number of business enterprises will not survive this – Cyprus will be destroyed.

    Why is this happening.

    Because of the rule that any any deposit under one hundred thousand Euros is “insured” (can not be touched – not even 10% of it). I can understand why – but…..

    This means that people who (for example) have ten thousand Euros in the bank wil not lose one thousand Euros (good). But it also means they will have NO JOB – because the business they worked for will no longer exist (bad).

    Also deposit insurance is SPREADING.

    One of the good things about the Channel Islands (Guernsey and Jersey) was that they had no “Deposit Insurance” – no moral hazard (no customers mislead into thinking banks were “safe” investments – so that they do not watch, every day, what the bank is up to) and no blank cheque of bank support for taxpayers.

    But how did the rulers of Guernsey and Jersey react to the events of recent years?

    They are creating their own schemes of DEPOSIT INSURANCE.

    It is all about “confidence” you see.

    Please note.

    Only a CONMAN worries about “confidence”.

    If banking was sound – “confidence” would not be needed.

  • waramess

    We might herald the demise of government guarantees, whether explicit or implicit but what happens then?

    This is a clear example of what happens when the governments squeeze the private sector out and take over the role for themselves.

    No public sector guarantee and no private sector insurance and absolutely no incentive for the private sector to remedy the situation whilst the banks pay such a low interest rate that default insurance would find few takers.

    The sooner that all governments stop the nonsesense of guaranteeing deposits the sooner the private sector can start operating a viable option to self insurance for deposit holders.

    If that is an end to democracy then, bring it on