The Cyprus banking kerfuffle has ignited a blogosphere storm debating the likelihood that depositors elsewhere, perhaps even ‘guaranteed’ ones, may find themselves on the hook for recapitalising their domestic banks. Largely lost in this discussion however is the unpleasant reality that a substantial portion of the international financial sector has been undercapitalised or even insolvent since at least 2008, if not before. Policy responses to the financial crisis have not changed this fact. Indeed, as resource misallocations are the ultimate cause of bankruptcy or insolvency, the exponential increase in price-fixing distortions in the wake of the global financial crisis ensures that depositors in aggregate are now facing far greater losses than they were back in 2008. Someone has to pay for past resource misallocations even when central banks succeed in sweeping these under the rug of monetary inflation. Will it be you?
THE BANKS ARE (STILL) INSOLVENT
You don’t need to live in Cyprus to be aware that banks in numerous countries are woefully undercapitalised, in some cases to the point of insolvency. Sure, regulatory financial accounting conventions allow for a huge amount of smoke-and-mirrors obfuscation, delaying the day of reckoning, but an insolvent bank is insolvent regardless of the regulators’ choices of accounting conventions to apply from one day to the next.
Although the specific distinctions vary from country to country, large banks have multiple sources of capital in their liability structure with varying degrees of seniority. As losses are incurred they are absorbed by this structure, tranche by tranche. First goes the shareholder equity, then the subordinated debt (which includes a great number of interbank derivative positions, about which more later), then the senior debt, then uninsured deposits.
Back in 2008, however, government and central bank officials chose not to follow existing law and apportion losses to banks’ liability structures through appropriate insolvency proceedings. Rather, they chose to go straight to the taxpayers to bail out their respective financial systems, in some cases by outright nationalising institutions. This was done because the institutions in question were deemed ‘too big to fail’ (TBTF) and their insolvency would have threatened to derail the entire financial system.
THE BANKER BAILOUT BACKLASH
This policy (mis)judgement, that socialising bank losses served the interests of society, has been the subject of much dispute, including in previous Amphora Reports and, more recently, in David Stockman’s outstanding new book, The Great Deformation (available on Amazon here). Indeed, as one banker scandal after another has come to light since 2008 there has now been a huge banker bailout backlash. Politicians understand that, in the event another crisis hits and the TBTF banks are at risk of failure yet again, taxpayers may refuse to support another systemic rescue. What to do?
Well, behind the scenes, economic officials the world over have been busy putting together working frameworks for how to deal with future bank failures. One recent, prominent example is a joint paper by the US Federal Deposit Insurance Corporation and the Bank of England, in cooperation with the US Federal Reserve and the Financial Stability Board of the Bank for International Settlements, the international bank supervisory body based in Basle, Switzerland . Given its international character and the prominence of the institutions involved, this paper should be understood as a working template for how large international bank failures will be addressed in future. The paper begins with an explanation of the problem (emphasis added):
The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.
The paper then proposes what appears, at first glance, to be an entirely reasonable way to deal with a possible future failure of such an institution:
[R]esolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.
Fair enough. How reasonable to actually have a framework in place that allows banks to fail without placing taxpayers on the hook. But as with many apparently reasonable policy initiatives, the devil lurks in the details, specifically in paragraph 13 (an appropriate number perhaps?):
An efficient path for returning the sound operations of the [bank] to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution. Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.
What this amounts to is a debt-for-equity swap arrangement for the “highest layer of surviving bailed-in creditors.” While in some cases the ‘highest layer’ might be that of the bondholders, in others it would include depositors, as is the case in Cyprus for example. Yet this is to be done while “subsidiaries carrying out critical activities would be kept open and operating, thereby limiting contagion effects.” So what, exactly, are these ‘critical activities’? And what is meant by ‘contagion effects’?
What the authors are referring to here is the interbank market, not only for wholesale lending in the money markets but also for all manner of financial derivatives and the underlying collateral on which they are, in some way, secured. This is what caught regulators by surprise in 2008: following the collapse of Lehman Brothers a fire-sale slump in collateral values led to a cascade of interbank margin calls and the market seized up, threatening relatively well-capitalised firms that had appeared previously not to be at risk. The paper thus implies that the way to prevent contagion in future is to prevent a sudden contraction in the interbank lending+derivatives market.
Think about this for a moment: The interbank market, a leveraged, inverted pyramid of subordinated debt built on top of a comparatively limited amount of senior debt collateral, is to be held intact by regulatory fiat while depositors are ‘bailed-in’ via a debt-for-equity swap. Do you see the sleight-of-hand at work here? Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!
In other words, regulators are laying the operational groundwork for a new type of banker bailout deemed politically acceptable. The last time around, they went straight to the taxpayers. The next time around, they are going straight to the depositors.
Now it so happens that depositors are never explicity mentioned in the paper. They are always referred to as ‘unsecured creditors’. But the effective meaning of this term is belied by the fact that the proposal assigns the FDIC the job of resolving US-based institutions via the debt-for-equity swap mechanism mentioned earlier. Were the bondholders rather than depositors in primary focus this would not be the case as the FDIC has no direct responsibility for the wholesale, non-depositor sources of credit to US financial institutions.
Finally, consider the brutal, unjust irony of the entire proposal. Remember, its stated purpose is to solve the problem revealed in 2008, namely the existence of insolvent TBTF institutions that were “highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements.” Yet what is being proposed is a framework sacrificing depositors in order to maintain precisely this complex, opaque, leverage-laden financial edifice!
If you believe that what has happened recently in Cyprus is unlikely to happen elsewhere, think again. Economic policy officials in the US, UK and other countries are preparing for it. Remember, someone has to pay. Will it be you? If you are a depositor, the answer is yes.
WHAT ABOUT GUARANTEED DEPOSITS?
What if your deposits are ‘guaranteed’? Does this mean that you will be excluded from abribtrary subordination? Perhaps. Perhaps not. Once officials start changing the rules they have a naughty tendency to keep right on going. That said, perhaps ‘guaranteed’ deposits are indeed sacrosanct in certain countries, if not in Cyprus. (To clarify, ‘guaranteed’ depositors in Cyprus are not participating in the debt-for-equity swap arrangement being implemented there, but they are subject to strict and indefinite capital controls. At best this is a huge inconvenience; at worst, a holding pattern prior to a subsequent future bail-in in the event that the unguaranteed deposits are insufficient to recapitalise the banks. A distinct possibility in my opinion.)
But step back for a moment. What, exactly, is a deposit guarantee? Who provides it? Why, the taxpayer of course. So to the extent that guaranteed depositors do not directly recapitalise failing banks, they do so indirectly as taxpayers. Remember, someone has to pay.
Recall, however, that the entire shift in focus from taxpayer-funded bail-outs to depositor bail-ins originates in the political backlash against the banks. Taxpayers don’t like being on the hook for corrupt bankers’ past mistakes. That said, they don’t much like being on the hook for anything. Take a look around at those large and growing public sector deficits and debts. Guess how they came about. They exist because countries have been resorting to inflation to finance their bloated welfare states as well as banker bailouts.
Economic officials may not care to call this debt-financing inflation, but inflation it is. Those debts are being financed, directly and indirectly, by rapidly expanding central bank balance sheets and associated broad money and credit creation. At some point in future, this monetary inflation will show up in consumer prices. It is just a question of time .
So in the end, depositors, guaranteed or not, taxpayers, and anyone not benefiting from inflation is paying for the resource misallocations that caused the insolvency of much of the global financial system. Unless you work for a leveraged financial institution or a government that spends money it doesn’t have, that ‘someone’ who pays probably includes you.
DEPOSIT ‘INSURANCE’ IS JUST PART OF THE NEGATIVE-SUM GAME
Common sense informs us that real risks can only be insured with real savings. This is one explanation for why countries with low savings rates tend to inflate their way out of economic recessions, rather than to restructure and resume healthy growth through Schumpeterian creative destruction. History suggests that the inflationary process becomes a vicious cycle as inflation further disincentivises savings, resulting in an even lower savings rate, followed by even more counter-cyclical inflation down the road.
As it erodes wealth, however, inflation is not a form of insurance. It is merely a means of reducing the real burden of unserviceable debts by transferring economic resources from savers to borrowers. A nasty side effect of inflation is that it causes resource misallocations and subsequent crises. Neo-Keynesian economic models refuse to acknowledge this but economists of many stripes including Richard Cantillon, Hume, Marx, Lenin, von Mises, von Hayek, Alan Greenspan and even Keynes himself were aware of it. With the notable exceptions of Marx and Lenin they also warned of these hidden dangers. (Marx and Lenin actually encouraged inflation as a means to confiscate wealth from the capitalists and concentrate it in a central bank owned and run by the state. The establishment of a central bank was plank 5 of Marx’s Communist Manifesto.)
To expand on a previous point, to the extent that it is applied to an entire financial system, deposit ‘insurance’ is therefore a misnomer. The only way depositors system-wide can possibly be made whole is by the state issuing a sufficient amount of debt in order to raise the necessary funds from the central bank. But as this is inflation, the very depositors being bailed out are the depositors whose wealth is being confiscated through inflation! System-wide deposit insurance is robbing Peter to pay Peter, so to speak. But if Peter doesn’t notice, will he object?
Sadly, whether we notice or not, the result of this game of robbing ourselves is not zero-sum but rather negative-sum: a ‘dead-weight-loss’ in the economic jargon. This is because the financial system is a huge consumer of misallocated resources that could otherwise be directed toward fulfilling the actual needs and wants of consumers. That’s right: alongside bloated governments, the greatest resource misallocation in the world today is that of the financial system itself, which has grown like a cancer ever since central banks wrestled control of the money supply away from the ‘golden anchor’ that, prior to 1971, largely kept it in check.
In numerous countries there is now much evidence that depositors are re-evaluating their trust in their respective financial systems and voting with their wire transfers. This is entirely understandable. Indeed, although it may go against the conventional wisdom, I would argue that the threat of a bank run is a healthy thing. How else to keep bankers in check, when the present system gives them every incentive to leverage up as much as possible, thereby concentrating profits in their hands yet socialising losses on the depositors and taxpayers via bail-outs, bail-ins and inflation?
How refreshing it would be to see banks competing on claims of depositor security for a change, as opposed to which bank has the friendliest image, the most fashionable logo, is the ‘greenest’, or occupies the tallest building in London or New York? Indeed, such faux competition highlights that banking is an industry sorely lacking in real competition.
Notwithstanding all the evidence to the contrary, some still call the bankers ‘capitalists’. While they’re at it, they might as well call the Communist Manifesto a capitalist work.
 The Amphora Report has tackled this issue on multiple occasions. Probably the most extensive discussion was in A TALE OF TWO CRISES, Amphora Report vol. 2 (December 2011). The link is here.
“Deposits” and “depositors” are wildly misleading terms – people LEND money to bankers (who, in turn, lend it on – and also build inverted pyramids of debt upon it), but they are misled into thinking they have “deposited” the money (as if the bank was some sort of warehouse or grain silo).
As for the future…..
Well the article seems to be clear – to take the American example, those people with one hundred thousand Dollars (or less) “in” (really lent to) banks will be “saved” by the government (by the production of more fiat money)and anything over this will be “converted” into (near worthless)bank shares.
No wonder people are trying to get their money back from the bankers – and putting it in shares (hopefully not bank shares).
However, the stock market is a bubble…..
If a more simple example is needed, I asked a client this,”imagine how you would feel if I called you one day and told you I had to sell some of your assets for cash to cover my gambling debts”. You can imagine his response. This cannot end well.
Wow, the EU have just reinvented the wheel and it is square.
A liquidation would probably mean that depositors would lose all their money and assets would be sold off to the highest bidder. New managment would then have responsibility for the purchased assets and, should they have messed up then they too would go bust.
The EU answer is for depositors to lose a lot of their money (but not all)and for most of the managment that committed the folly to remain in charge of the assets not written off.
So, Socialists are not the enemy of capitalism after all but great buddies, having saved theiir mates from losing all their money and at the same time saving their other mates from losing their jobs.
See the contrast with those evil capitalists and weep.
A technical point – am I right in thinking that gambleing debts are not enforceable in law? Do not worry I do not have any – it was just a thought.
As for capitalism.
The capitalists are the people who own the banks – who have been wiped out (their shares are worthless).
But, to the joy of the Financial Times and so on, owners no longer run business enterprises such as banks (hired managers do).
And, yes, the “wage slave” top hired managers are doing very nicely thank you.
Marxism – for the top managers (private ownership, state ownership – what difference does it make for most of them?).
What everyone forgets is these deposits are for many many poeople their pension
Theres too big an assumption that money saved in Banks and Building Societies is simply FUN MONEY everyone can afford to loose
Its the same situation with Low Interest Rates
People like me have absolutely no option but to rely on the interest from my savings because i only get half state pension and have no other company or private pension
To rob me of my savings or my interest is to reduce my life to existing on £66 a week after a lifetime of prudence and makinhg do and mending it simply is not acceptable
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