Wednesday, 20 March 2013

Sham guarantee

So you think small bank deposits are guaranteed, do you? That they are perfectly "safe"? Read what follows, and think again. 

The Eurogroup President's statement on Cyprus included the following commitment (my emphasis):
"The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000".
Ok, so that's the standard line on deposit insurance. Small deposits, including current accounts, are safe from loss because they are 100% guaranteed by government.

Here's the President of Cyprus on the subject (again, my emphasis):
The State would be obliged to compensate depositors in response to the obligation regarding guaranteed deposits. The capital required in such a case would amount to about 30 billion euros, which the State would be unable to pay.
Indeed it would not. After all, the reason for the proposed depositor haircut is that the Cypriot government can't afford to borrow even 7 billion euros, let alone 30 billion. Actually the Cypriot government can't borrow at all, really. Its credit rating was cut to junk quite some time ago and the only buyers for its debt now are the same banks that are threatening to implode if they aren't recapitalised.

Tim Worstall thinks that deposit insurance payouts are the responsibility of central banks. No they aren't, at least not in the Euro area. They are the responsibility of member state governments. And the ECB is not going to create money to meet the obligations of member state governments - even when those obligations are mandated by European Union directives, as is the case with deposit insurance. Nor could the Cypriot central bank create the money, either. Euro area member state central banks are subject to the ECB and can only issue money in accordance with its rules and under its supervision. At present it is by no means clear whether the Cypriot central bank will be allowed to continue creating money to fund the Cypriot banks under the Emergency Liquidity Assistance (ELA) scheme: the disastrous "burn the depositors" scheme was agreed in response to an ECB threat to withdraw funding, and although the ECB appears to have backed off from this at the moment, there are still no guarantees that it won't follow through on its threat at some point. Hell would freeze over before the ECB gave permission to the Cyprus central bank to create money to compensate depositors on behalf of the Cyprus government.

So the Cyprus national government can't borrow to meet depositor claims, and it can't print money to meet their claims either. And it has insufficient tax income even to meet current spending obligations, never mind insurance claims. This is not looking good for depositors, is it?

Well, I suppose it could sell some assets. Or, even better, the banks could, so that the Government didn't have to meet depositor claims. The President had something to say about this too (once more, my emphasis):
A proportionate amount corresponding to the deposits of thousands of depositors for deposits over 100.000 Euro, would be led to a vicious cycle of asset liquidation, and these depositors would suffer losses of over 60%Such an uncontrolled situation would push the whole banking system into collapse with all the attendant consequences.Thousands of small and medium enterprises, and other businesses would be driven to bankruptcy due to their inability to trade.
Oh. So liquidation of bank assets wouldn't raise anywhere near enough to meet depositor claims, and would wreck the entire economy. Why on earth are these banks still allowed to trade? However, Cyprus is a rich country - isn't it? At least, according to "genauer" in a comment on FT Alphaville:
Cyprus is very rich. Lots of drilling rights, lots of private wealth to be taxed.Just not as immediate cash on hand.
That the sacred TFEU rights of the (poor) Euro taxpayers should be violated, to smoother rich tax havens, is hilarious.
Well, this is not quite what it seems. Taxing private wealth is not as easy as it sounds, especially when most of that wealth is in your financial centre (which is being trashed anyway). Large deposits made by rich foreign oligarchs and multinational corporations to reduce tax liability in other places tend to evaporate like the morning mist when you attempt to tax them. And drilling rights? There appear to be deposits of oil and gas in that part of the Aegean, to which Cyprus claims rights. But it is by no means clear to what extent those deposits are realistically exploitable, nor whether Cyprus really can lay claim to them. Turkey thinks otherwise, and has already made it clear that it will not tolerate any attempt by Cyprus to exploit those deposits. (Turkey of course not only claims those deposits, it claims Cyprus itself.) Egypt also disputes Cyprus's claim.

So not only does Cyprus not have liquid assets, it may not actually have exploitable assets at all. It has some ports that could be privatised - the IMF is keen on that idea. And it has two British naval bases. It could auction those off, perhaps? Well, only if the UK Government agreed, which might be tricky. And I'm not sure how the possibility of Russia or China buying these strategically-important bases would be regarded by the US, which is watching the Cyprus affair from across the Pond with some concern. 

The experience of Greece shows that forced sales of state assets to meet government obligations is fraught with difficulties, can be extremely slow and may not raise the expected funds anyway. And the precarious political position of Cyprus, at the gateway of the Middle Eastern melting pot and partly occupied by Turkey, doesn't bode particularly well for foreign investors.

So Cyprus can't borrow, can't print, can't obtain enough money from liquidating bank assets and may not be able to raise enough money from sales of state assets to meet depositor claims. Depositor insurance doesn't look like it's worth much, does it?

But - this is an EU deposit insurance scheme. Surely the EU would step in to ensure that depositors were compensated under the terms of its scheme?

Dream on. Germany has made it clear that a common deposit insurance scheme is simply not up for discussion. No way are German taxpayers going to fund the claims of Cypriot depositors. As "genaeur" puts it:
the national bank guarantees are to be paid nationally,as everywhere else.
And this is the heart of the matter. The Eurogroup's "full guarantee of deposits below E100K" is unfunded and therefore untenable. The Cypriot government cannot afford the deposit insurance to which it is committed under the EU Directive, and other states won't help. Cypriot deposits are not guaranteed and it is positively evil of the Eurogroup to give depositors the impression that they are.

The proposed deposit haircut of 6.75% for deposits under 100,000 Euros looks harsh and unfair. And indeed it is. But not because deposits were ever "safe". Compared with the alternative - bank failure, sovereign insolvency and unrecoverable loss of most of their money - this was a good deal for small depositors. And it may still be improved. 

What is harsh and unfair is that depositors have been led to believe that small deposits were guaranteed, when the supposed "guarantee" is not worth the paper it is written on. In the Eurozone, deposit insurance is only as good as the ability of the sovereign to honour it. If the sovereign cannot honour it, it is worthless. And that is the situation not only in Cyprus, but also in Greece, Portugal, Ireland and possibly Spain. None of these sovereigns could borrow, print or otherwise raise the money to meet claims under the EU's deposit insurance scheme. 

It is time that depositors were told the truth. The lack of a common deposit insurance scheme in the Eurozone means that deposit insurance is a luxury available only to those countries that can afford it - which are also the countries that least need it. Everywhere else, it is a sham. 


Related links:

Sowing the wind - Coppola Comment
Gas in Cyprus - how much of a guarantee? - Nick Butler, FT (paywall)
Cyprus bailout: Welcome to another Great Depression - Tim Worstall, Forbes (annoying video ads)
Doubts over Cyprus gas bonanza - Guardian
Cyprus, Fight Club & Capital Controls - Pawel Morski. Read his previous two posts on this, too. 
EU single market: deposit guarantee schemes - European Commission
Privatization of Greek assets runs behind schedule - NPR
Wanted: EU banking union as Cyprus kills off deposit insurance dream - Euromoney

Plus the entire FT Alphaville series on Cyprus, which is brilliant.

45 comments:

  1. Do you think tulips could be the answer?

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    1. Tulips aren't worth as much as they used to be!

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  2. "The lack of a common deposit insurance scheme in the Eurozone means that deposit insurance is a luxury available only to those countries that can afford it - which are also the countries that least need it."

    Very good point!

    "Tim Worstall thinks that deposit insurance payouts are the responsibility of central banks. No they aren't, at least not in the Euro area. They are the responsibility of member state governments."

    Right! Just because the central banks/Eurosystem has powers of credit creation doesn't automatically mean they have to guarantee deposits.

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    1. Deposit insurance is a political thing in order to build trust into the EURO.

      See the E.U. wanted to become a state but it's still missing a folk. So the E.U. tried to bring together the European folks with the help of the EURO. Seems to be French thinking.

      This dream is dead. And that's what Cyprus is all about. There are many other reasons why Cyprus is somehow interesting but in the end ... States are taking away competence from Bruxelles and honestly it's the end of the E.U. Cyprus is not the reason it's the trigger.

      In practice no country in Europe could stand insuring the deposits if big banks fail. Austria is a good example. The balance sheet total of the Austrian banking system is about 250% (iirc) of the Austrian GDP. The money is in East Europe and East Europe is recessive.

      At the moment the write offs are eating up the international banks profits, but the international banks are backed up by a network - associations of savings banks. All the others have lot bigger problems.

      Imo the best assurance is to decide for a bank with a solid business or a structure that is in the position to cover risks in a self sustaining fashion. Everything does not go wrong contemporaneously.

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  3. Do you really believe the ECB will allow Cyprus to default? This would seem to significantly undermine the "whatever it takes" claim by Draghi. If Cyprus is allowed to default on ECB loans or leave the Eurozone, I don't see how the bargaining positions of other peripheral countries isn't drastically improved.

    My take is that Draghi is basically bluffing and the Cypriot no vote basically called that bluff. If Cyprus stands strong I think Draghi will ultimately bend the ELA rules to allow funding for worthless assets.

    One other question, why is so much effort being made to save Laiki bank if it is in fact as insolvent as everyone claims?

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    1. Failing to honour bank depositor claims is not sovereign default in the normal sense of failing to service international debt obligations. If the choice were between servicing international debt obligations and honouring depositor claims, I have no doubt that the Eurogroup would enforce the former at the expense of the latter. Indeed, that is effectively what the depositor haircut would have done.

      Laidi is being saved for the same reasons as all other insolvent banks - systemic importance, particularly to the domestic economy. Look at Bankia, Dexia, Monte dei Paschi....

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    2. sorry, fat finger....should be Laiki, of course.

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    3. Replying to Frances' comment on Bankia in Spain - Bankia was not systemic, it was Madrid banks and savings banks, basically run by and for the ruling PP party, intentionally swollen by last-minute mergers with an assortment of basket cases so the Spanish government could then claim it was systemic and had to be saved. Madrid city neatly preserved its central bank at the expense of most of the provincial banks, it's not a question of "domestic economy" it was ideological manipulation. Europe is being taken for a ride, or is collaborating in some very shady deals, at the expense of tax-paying Europeans who did not vote for their money to be used like this. You can't take these things at face value. (That's just one view that's around in Spain but it looks likely.)

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  4. Well exactly. Why the current EZ does not work exhibit 322. I don't agree with deposit insurance but that is the system we are supposed to have. However, the theory behind deposit insurance is the insurance guarantee prevents the insurance ever being called. Effectively, providing a guarantee stops depositors causing banks to be illiquid. However, no one ever imagined that a central bank should provide liquidity to an insolvent bank.

    Cross border lending for small countries in a monetary union without a banking union is a nonsense. People obviously see a haircut on depositors as an outrage because it breaches the guarantee. However, that guarantee was never credible in the first place because the one providing the guarantee could not have the resources to make good. EZ banking is already rationally retreating behind national borders, so the EZ system is already failing. If the EZ is to continue I don't see any future for small countries having their own banking system. The powerful countries that do have the resources that prevent these type of things are never going to agree to common deposit insurance without fiscal control over the weakest links.

    Difficult to see a way out of the mess that is politically acceptable. Their problem is undercapitalisation, so only an injection of capital can solve their crisis. Not that much bank debt that can be written down.
    http://www.openeurope.org.uk/Article/Page/en/LIVE?id=10072&page=FlashAnalysis#_edn1

    An injection of capital that makes their debt unsustainable is obviously not going to help. Possibly GDP bonds that only pay out if growth is above a certain threshold could be something that foreign states would buy. The ECB can't make good on deposit insurance, that would be a backdoor banking union imposing the costs on all the rest of the members who are ECB capital holders. One thing that is certain is the banks will not reopen until the problem has been solved. If the ELA or ECB declare their collateral is not eligible, that effectively pushes them out of the EZ. We then turn and ask who is next.

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    1. "If the EZ is to continue I don't see any future for small countries having their own banking system."

      What is a small country in a currency union? I have never seen the point of the national 'central' banks in the EZ other than as a political pressure on the ECB itself. If the EZ is ever going to work, then the ECB needs to be in charge and banking union at least is inevitable.

      If national governments are mandated to guarantee 100kEUR, then the mandating authority must stand behind that, even if Germany doesn't like it. Otherwise it is a very interesting legal situation of competence and depositors in Cyprus may well take legal action, as well as that on the street.

      I strongly suspect that Cyprus as a small country is being made to suffer to encourage the others. It wouldn't make much difference to the Euro if Cyprus were expelled, followed possibly by Greece. No doubt to the smirking pleasure of both Berlin and Ankara.

      In the UK this is being reported with a strong does of schadenfreude and serves to deflect attention from Osborne's mess.

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  5. If there is one thing more shambolic than thy Cyprus chaos, it’s the total failure by Frances, Ramanan or Joshua Wojnilower above to produce a solution.

    Frances simply suggests telling depositors their money is not safe. I flatly reject that: it’s a fundamental human right to have access to a 100% safe account. Moreover, there are firms or entities which have a LEGAL OBLIGATION to lodge money in a 100% safe fashion, e.g. lawyers looking after clients money.

    Sorry to keep banging on about it, but there is a very simple solution, as follows. Just give depositors a choice between two options. First they can have their money kept in a 100% safe fashion. And 100% safe means 100% safe means 100% safe means 100% safe.

    Hope I make myself clear.

    I.e. the relevant money is not loaned on or invested. It’s just lodged at the central bank.

    The second option is for depositors to have their money loaned on or invested. But in that case they have no moral right whatever to any sort of taxpayer funded guarantee or subsidy. Those making investments via the stock exchange get no taxpayer funded guarantee. Families who invest in a small business out of their own savings get no taxpayer funded guarantee. Why should those to make investments via a bank get any sort of guarantee?


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    1. Ralph

      I have two rules about comments on my blog:

      1) please confine yourself to the topic of the post

      2) please be polite and refrain from personal attacks on me or on other commenters.

      Your comment here breaks both rules. The tone of your remark is aggressive and you attack me and two other people. Further, you ignore the content of the post. The solution you propose requires there to be a functioning central bank. I made it very clear in this post that Cyprus does not have a central bank. The only other alternative as a full reserve host is therefore the ECB, which would require full banking union. As I ALSO pointed out in the post, this is not even up for discussion at the moment due to absolute opposition from Germany.

      I will not accept further comments from you that attack others and grandstand your beliefs without regard to the content of the post.

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    2. If it’s not possible the have full reserve in one country within the EZ without the whole of the EZ switching to full reserve, then my answer is “have the whole EZ switch to full reserve”. After all, the Cyrus problem is not unique to Cyprus. Ireland, as well all know, had a catastrophic banking problem which it COULD HAVE ameliorated by shafting depositors – instead it chose to shaft taxpayers.

      However, I don’t actually see why IN THEORY one country within a common currency area couldn’t switch to full reserve. (In contrast to theory, I’ll ignore the legal details currently governing the EZ.)

      The government of such a country would in effect announce “if there is anyone out there who wants 100% safety for their money, just give it us, and we’ll lodge it at the ECB”. There’d be no need for anyone to actually write out cheques to the relevant government: commercial banks would act as agents for government, and government would doubtless only award “agency rights” to responsibly run banks. I.e. dodgy shadow banks would not get agency rights.

      And as for depositors who wanted their money loaned on, government would make the same announcement as it would in the case of a monetarily sovereign country, i.e.: “Your’re on your own. Don’t come running to us if your bank is in trouble.”

      Incidentally re your claim that “I made it very clear in this post that Cyprus does not have a central bank”, you actually said in the post that “Nor could the Cypriot central bank create the money…”. More generally, every country in the EZ has its own central bank doesn’t it?


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    3. Ralph,

      A central bank that can't create money to support its sovereign isn't a central bank. The Cypriot "central bank" is a central bank only in name. Cyprus has no central bank in any normal sense of the word.

      There is no way a member state could "go it alone" on full reserve banking as you suggest. The money may be parked at the ECB but the liability would remain with the banks that lodged it there. The ECB has no mandate to protect customers from bank losses or to recapitalise banks. And it ranks senior to bank customers: in the event of a bank failure, any money parked at the ECB would remain at the ECB to shore up its own balance sheet and customers would bear the losses.

      I find your faith in "government" touchingly naive. Have you never heard of political corruption?

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    4. Nor is the ECB a central bank in real terms.

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    5. Frances,

      Re your claim that “The ECB has no mandate to protect customers from bank losses..” that point is of very limited relevance because it’s near impossible for commercial banks to fail under full reserve. Reason is that EITHER depositors’ money is lodged at the central bank, in which case it cannot be lost, OR it is loaned on, in which case the relevant depositors carry the risk, not the commercial bank.

      But if a commercial bank DID GO BUST, then I agree the ECB has no mandate to rescue it. But under full reserve, it WOULD HAVE an obligation to look after funds lodged by those who wanted their money to be 100% safe.

      Re your claim that my faith in government is “touchingly naïve” and your querie as to whether I have ever heard of political corruption, my response is that given the fact that commercial banks are run by spivs, criminals, fraudsters, etc who have been fined BILLIONS for their crimes, I find you faith in commercial banks equally naïve.

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    6. Ralph
      The ECB will protect its own balance sheet first and foremost, if necessary by withholding customers' money. I repeat, it has NO mandate to protect depositors, however much you might like it to.
      I am well aware of the problems in bank management. What I find naive is your apparent belief that politicians are trustworthy. I don't trust politicians any more, or less, than bankers.

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  6. What you want Ralph is not a bank, it is a vault. A safety deposit depository already provides that service to people who want to store valuables. Quite rightly they charge people for storing their items. Why would a bank store money for people for free or even pay a customer for the storage. If there is such a demand for vault only banks why are people not setting them up? They would not need much capital for vault only because they would not be engaging in lending.

    A human right to storage for money is nonsense on stilts. Do people have a human right for somewhere to store their jewelery? A human right for somewhere to park their car? Deposit insurance is defensible if the bank is engaging in lending because the bank could end up illiquid or insolvent. However, there is no case for the state guaranteeing the deposits of someone who just wants somewhere to store money. Buy a safety deposit box would be my advice. The idea would be as much a direct state subsidy as guaranteeing luggage storage boxes in stations.

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    1. Richard - "Why would a bank store money for people for free or even pay a customer for the storage." Wasn't that what Savings Banks used to do? But noone expects a service to be free. Most people consider banks a service and use them like safes anyway. What they have turned into is fine, maybe this new concept should just change its name and leave ordinary people with their one-horse old-fashioned service - the bank (paying, naturally).

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    2. Marga, the problem is that most people also expect to be paid for depositing money in banks. The idea of paying for a safe deposit service for bank deposits, and receiving no interest, would provoke outrage.

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    3. This is a fair point, but I don't think a problematic one. In some countries you already pay for your current account. Running a few computers and admin besides is not expensive. Besides if people dislike being charged directly for custody, you can put the charge on the transactions in and out. It may be hard to sustain things like free ATM withdrawals but then they're already subsidised where they are free (ATMs are never free to operate).

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    4. Richard,

      You are quite right to say that full reserve involves banks acting as vaults – at least that’s true for those depositors who want their money to be 100% safe. You then ask, “If there is such a demand for vault only banks why are people not setting them up?” The answer is simple: under the existing system, depositors can get the twin advantages of 100% safety (thanks to the taxpayer) plus the advantages of having their money put at risk, i.e. invested. I.e. if you can have your cake and eat it at the expense of the taxpayer, then you might as well go for that option. That’s why there is little demand for “vaults”.

      Next, you argue that because having somewhere to store your jewellery is not a human right, ergo having somewhere to story your money is not a basic human right. The two are entirely different: jewellery is a LUXURY. Money is an absolute ESSENTIAL – e.g. for buying food, etc.

      Next, you say “Deposit insurance is defensible if the bank is engaging in lending because the bank could end up illiquid or insolvent.” OK . . I can apply that argument to the Mafia: “state subsidies for the Mafia are defensible if the Mafia is engaged in lending because otherwise the Mafia could end up illiquid or insolvent.”


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  7. So Mr. President, you have guaranteed small and medium savers in your banks up to a total of €25 000 per head of Cyprus population and you don't know how to fund that. Frankly Mr. President, I wouldn't have started from here.

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  8. The British bases are sovereign territory sadly, so no chance of the Cypriot government using these- unless it wants to annex a part of the uk!

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    1. Neither of them are Naval Bases either. Dhekelia is landlocked and there aren't any significant piers either at Akrotiri or Episkopi.

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    2. SE Military bases, then. My bad.

      Proux - I know the bases are UK sovereign territory. But the Cyprus govt claims them, of course. Hence my suggestion. Though the Cypriots would have to negotiate hard with the UK to get any title to those bases - national security always trumps territorial claims - and I'm not sure they have much to offer in return.

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  9. Thanks Frances for a clear and easy to understand explanation of the situation. As you say, the relevant authorities should be honest about their inability to protect deposits, but I guess many folk wouldn't have left their money in the accounts had they been fully forewarned. Do you see a significant knock-on effect from the fallout from this crisis?

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  10. I believe you have misunderstood the German position. I think the mainstream German view (at the politicians level at least, SPD and CDU) is that full banking union including an ECB deposit guarantee (or common bonds, similarly) goes with federal institutions that essentially have the matching tax-rising powers and distribution channels, and political accountability (a eurozone parliament, or an enlarged role for the existing one, or the like). The problem here is that takes years, and at the moment the largest obstacle for this are probably the French who're still on some silly sovereignty trip (and incidentally we'll get Brits trying to sabotage any further European integration even for things they don't take part in, which slows things down).

    That is in an emergency, which Cyprus is not (yet), they could relent and allow ECB to backstop deposit before the Brits are finished with torpedoing the federal work. Angela Merkel is anything but flexible, she changes views nearly as often as she changes her outfit's colour (and is universally both mocked and loved for it).

    On the Cyprus can't pay the deposit guarantee issue, it's not so clear to me. They only need the 30 billion if 100% of deposits go away and 100% of the assets are illiquid. An Icelandic solution -- put the best 30B of assets opposite the 30B of deposits truncated at 100K in a good bank, with branches etc, all the rest in a bad bank -- would probably work, and the ECB would probably be OK to ELA match the entire 30B worth of mundane assets in the unlikely event of a 100% deposit flight. Here the stumbling block seem to be Cypriot MPs who seem to hang on the hilarious idea that they still have a financial industry worth saving.

    Otherwise the best solution I've seen so far is the Lee Buchheit one: http://ssrn.com/abstract=2235359 (which is sort of a hybrid between the depositor tax and the Icelandic one).

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    1. It probably isn't clear from the post, but I actually have some sympathy for the German position. Deposit insurance with no banking union and no fiscal conditions would effectively mean a never-ending German gravy train for weak banks. But it does mean there is no backstop for those weak banks, so small depositors are at risk.

      I don't agree with you that the problem is Cyprus's attempt to salvage its financial industry. Everyone knows it is toast. The real problem is Russia, which has made it very clear that it would not take kindly to being forced to play UK to Cyprus's Iceland in order to protect German taxpayers. Given Russia's control of energy supplies in the region, upsetting Russia is really not a clever thing to do. Putin doesn't play nice.

      This is no longer a Eurozone crisis, or even a European Union crisis.

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    2. I don't talk about conspiracy now. Well informed sources from Germany mention. Whatever the reason may be, the E.U. wants/has to give up Cyprus and Greece. I don't know if the source is right. Spain, Italy as well as France simply miss their capability to devalue their currency, Spain does have to live with the result of the economic bubble too.

      The story in Greece and Cyprus seems to be a different one.

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  11. Hi Frances, I wonder what could have been the cost to let the banks such as RBS and co to crash and reimbourse the depositors, isn't UK also have a "insurance"?? I was definitively not a supporter of banking rescue however with your post in mind, at least maybe some lights are appearing and indeed it is no longer a Eurozone or even a European Union crisis....

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    1. In my view Northern Rock, Bradford & Bingley and Dunfermline Building Society all should have been allowed to fail, salvageable assets sold and the depositors reimbursed. But the problem with RBS and Lloyds/HBOS is their importance to the payments system. Just imagine banks closed, ATMs broken, electronic payments not made, wages not paid, cards being declined. We had that for 3 hours recently when RBS had a systems failure, and it caused problems for lots of people. If RBS or Lloyds had been allowed to fail, it would have been the same thing but on a massive scale and for days or weeks on end. Believe me, we don't want to go there. And we did come dangerously close to it in 2008 - we were about half an hour away from ATM closures when RBS failed. The emergency bailout of RBS prevented a catastrophic economic crash - it would have been worse than that experienced by the US, since RBS is a retail bank whereas Lehman was an investment bank. Possible losses for depositors is the LEAST of the problems with a bank failure on the scale of RBS.

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    2. Sorry Frances, I always thought that the retail part of banks were acting or should have behave like utilities companies (connected to an interdependent "grid")especially for payments systems obviously I was under an erroneous supposition.

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    3. In the UK the ATM network is run by the banks themselves, so a major bank failure is likely to bring down the entire network. Other payments systems such as BACS, CHAPS, VISA are separate companies, but the banks are the gateway. A major bank failure causes gridlock in the payment systems themselves in much the same way that closure of a major airport causes gridlock in the air traffic system - payments in transit have to be returned or diverted, new payments have to be stopped and there can be liquidity problems in the payments systems themselves (sort of analagous to diverted aircraft running out of fuel). Central banks can ease the liquidity problems but they can't do anything about the payments chaos, which is seriously detrimental to the economy as I'm sure you can imagine. It doesn't matter that the payments companies are private - the same gridlock would still happen if it was a nationalised network.

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    4. So RBS, Lloyds/HBOS will ALWAYS be "Too Big To Fail" then? How do we remove that moral hazard?

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    5. But putting the corporation into bankruptcy needn't shut them down. That's what really should have been done.
      The shareholders get wiped out, the management turfed and the assets and liabilities unwound. The banks shuts on a Friday and opens Monday with new owners i.e. receivership.

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  12. Thanks a mil...Frances, I was not aware of this and could you believe I worked for some years with ING bank however at my disacharge as a Building Project Engineer...

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    1. Payments systems are a bit of a mystery to most people. They are the "plumbing" that we don't see. Even if you work in a bank you may not be aware of how payments systems function. For my sins, I've actually worked on payments systems though I wouldn't call myself an expert - but a good friend of mine is an expert and I pick his brains from time to time.

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  13. The main problem in the UK during 2007/08 was the law. Forced conversions to equity for bondholders would have been the ideal solution to prevent the Treasury becoming an equity holder. That would have forced a huge haircut on bondholders and kept RBS and HBOS solvent without recourse to taxpayer funds. Some people deny they were insolvent and claim government overreaction to supposed undercapitalisation caused the very undercapitalisation that required the injection of taxpayer capital. Basically they believe illiquidity events were allowed to spiral into capital problems because of the inadequacy of the BoE, and the misdiagnosis from the Bank to the Treasury.

    The problem that is often implicitly ignored in hindsight analysis, is there was no legal means at the time to convert bondholders against their will. The law was very much on the bondholders side and the senior bondholders were legally first in the queue. Therefore, "they should just have let the banks fail" notion implicitly assumes a normal bankruptcy scenario. Even with the government paying out quickly on deposit insurance, a quarter of all UK salaries at the time were being processed by the RBS group. a third of all daily UK electronic payments. Just think the chaos that would have ensued as hundreds of thousands of businesses had their money stuck behind bondholder for years as liquidation proceeded, with no guarantee that they would get it all back. I don't see anyway that letting RBS go into bankruptcy with the law as it stood at the time would not have collapsed hundreds of thousands of unrelated firms. The economy did go down but the UK economy would have suffered an unprecedented collapse.

    We will never prevent banks getting into trouble because of the nature of borrowing short and lending long. Nor should that be the overriding aim of regulation. A good resolution system when they do screw up that protects the economy and does not rely on taxpayer funds should be the aim. That simply did not exist in 2008.

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  14. Richard, Thanks for the explanations, while I can understand the implications for crashing HBO and RBS at the time,in my view and with the actuals events, it appears that the Governement and BOE took the "slow motion" collapse's route... That we want it or not it seems we are at a cross road... to quote Roger Waters (it's a miracle) " By the grace of the allmighty and the pressure of the market place, the human race has (started) civilized itself!" (at last!)

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  15. I would close the bust banks, and pay out the depositors in the only currency I have - Cypriot government bonds.

    Similarly I would recapitalise the banks using Cypriot government bonds, with a view to privatising the new bank in due course

    Then let the ECB refuse to accept Cypriot government bonds as ELA collateral.

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    1. I don't see why the Cypriot government should encumber itself with future liabilities to bail out some random bank creditors. There's no scenario where it is a good idea: if they stay in the euro, it's a liability, if they don't, they can as well print currency directly, banknotes always look prettier than bonds.

      It seems that the law voted yesterday is a much better idea: good/bad bank split, >100k creditors in the resolution queue. Basically they seem to be doing the right thing with inelegant timing (it would have been neater to have bank resolution law ready earlier than on day 5 after an actual operational bank failure...)

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  16. Hi Frances, I'm glad I found your blog commenting on the Cyprus crisis. And pardon me if I will sound completely CLUELESS in my coming question. I am still trying to wrap my head around the whole claim that Cyprus would go bankrupt and dead-ends for its banks without the EU bailout scheme.

    So, since the EU proposed that the Cyprus banks tax their depositors to partly compensate and qualify for the bailout scheme, does it not mean that there are large amount of CASH readily available in the banks, immediate or not, which would prevent the banks from collapsing, so why would such an "end-of-the-road" claim being made that the banks and the entire sovereign will collapse without the EU bailout, regardless of how the bailout scheme will be finally constructed (i.e. by taxing the banks depositors or any other austerity-prone measures)? In other words, what has originally gone wrong in the Cypriots banks that gotten the country into this mess?

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    1. No, banks have generally no (or very little) money. What the "levy" on deposits does is not to move cash from a giant pile of available cash to another -- there simply isn't such a pile -- but to simply truncate liabilities that are not matched by assets.

      Imagine you've lent £100 to a friend, and then, on the day they are due to repay you, they have only managed to collect £60. You deciding to forgive them and accept £60 instead of the full amount is the same operation as the deposit levy in Cyprus. Neither you nor your friend have the £40 you're forgiving.

      Banks are really social networking platforms that allow people to lend to each other. They only keep petty cash so when people who borrow fail to repay they have to fail the people who made the loans, or get some external entity to make a donation.

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  17. Ralph, I put that qualifier in about deposit insurance because I do not believe in deposit insurance. However, I accept there is a valid argument in favour of deposit insurance. On balance, I believe deposit insurance offers depositors a sense of security that makes them lazy. Moreover, depositor disinterest in the safety of where they deposit their money leads banks to engage in unsafe levels of leverage. If it was up to me there would be no deposit insurance, but that is a minority view. The electorate like their implicit subsidies.

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