Euro zone crisis What does a guarantee mean?

The Economist, March 2013

DEPOSIT insurance schemes were a product of the 1930s, when the loss of confidence of savers caused the collapse of many small American banks, worsening the Great Depression. The practice became widespread from the 1970s onwards, with the number of countries using such schemes rising from 12 to 88 between 1974 and 2003, according to an IMF paper. The argument for deposit insurance is that banks are inherently unstable, by virtue of their economic function; they borrow money in the form of deposits (which can be instantly withdrawn) and lend to businesses on a longer-term basis. They are thus vulnerable to destabilising and self-fulfilling bank runs. But the counter-argument is that of moral hazard; depositors have no incentive to choose between banks on grounds of riskiness, and bank executives can take risks knowing that they are underwritten by the insurance scheme.

Some jurisdictions tried to offset this by limiting the guarantee; such was the case in Britain up until 2007, when only 90% of deposits between £2000 and £35000 were covered. But the Northern Rock panic showed that even the prospect of a 10% loss caused panic so the scheme was quickly extended. A deposit insurance scheme is designed to cope with the failure of an individual bank. But it may cause the entire banking system to become riskier. The IMF paper argued that explicit deposit insurance has been shown to increase the likelihood of bank crises significantly. Combining deposit insurance with interest rate liberalisation makes moral hazard even worse because it permits banks to chase high-yield investments carrying heightened risk

If the entire banking system becomes risky, then the risk of an insurance scheme falls on the state. But if, as with Cyprus, the banking system is much bigger than a country's GDP, than the state will be overwhelmed. The guarantee is only as good as the guarantor. The depositors become dependent on the willingness of foreign creditors to uphold the guarantee, and as Cypriots have found to their cost, that cannot be taken for granted. The same was true of Iceland, of course. Some Britons rushed to put their money into Irish banks in 2008 when the Dublin government guaranteed all bank deposits but, as was pointed out at the time, the Irish government could not create pounds. It cannot create euros either. In countries which can print their own currencies, governments can guarantee deposits in nominal terms, but not in real ones. The low interest rates that have propped up the banking system have eaten away at the purchasing power of savings; since 2009, British savers on a 40% tax rate (around 3.8 million middle class people) have seen a 6% decline in the purchasing power of their savings (a 6.6% gain in the best accounts, compared with a 13.4% rise in prices), even if they put the money in the best-paying accounts. That is on a par with the lower Cypriot levy.

But back to moral hazard. Let us assume that a EU-wide deposit insurance scheme was in place. The price would be greater bank regulation; it would certainly include greater controls on the ability to open a bank account and, perhaps, limits on savings rates. After all, if all banks had equal legal protection, investors would scour the continent in search of an extra few basis points; the flows could be destabilizing. Unless a country has strong banking regulation, a strict failed bank resolution regime, carefully designed deposit insurance with safeguards against risk, healthy private monitoring, and, most of all, strong institutions, explicit deposit insurance will only be a recipe for future bank crises.