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 thusly:

“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. It 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, then the banker could not lend the money to a third party against interest. He could not then 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 safekeeping 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, then the depositor must have at least implicitly agreed 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, no rational person claimed that the depositors were unfairly “bailed in” (a bail-in is an agreement by creditors to roll over their short-term claims or to engage in a formal debt restructuring with a troubled country) or were the victims of “theft.”

Although the mechanics of fractional-reserve banking have not changed in 300 years, the public’s expectations have greatly changed. Today, banks are expected to lend more generously than ever 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 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.

Eventually, the state does what it always does, i.e., 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. The Cypriot state, still the local monopolist of bank licensing and bank regulation, simply 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, nor do they 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. Rather, in their proper role as creditors to the banks, they would become “deposit vigilantes” and would help keep the banks in check.

In order to gain and maintain the public’s trust, the banks would again have to communicate balance sheet strategy and risk management to the wider public, 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.

The wider public would begin to appreciate how dangerous the populist policies of cheap credit and naive demands for “getting banks lending again” ultimately are. The depositors would finally realize that they’re underwriting these policies and that they carry the lion’s share of the risks.


Detlev Schlichter
This article originally appeared here.