A New Road-Map for Deposit Insurance

photo: flickr.com (CarbonNYC)

photo: flickr.com (CarbonNYC)

Chatting with one of Europe’s former central bankers recently, we discussed how Cyprus could have been handled differently, and what it all means for European banking integration and deposit insurance.

We should use the time that has passed since the Cyprus bail-in to re-think a fairer and less harmful way of restructuring banks and criteria for when and how to bail in depositors.

Readers of this blog will know that, in cases where the other assets of a defaulting bank don’t suffice, I support the controversial idea of depositor haircuts. I blogged extensively on and during the Cyprus bank restructurings [1], so my opinions on what is and what is not right are known.

With the benefit of time and experience since the Cyprus deal, the following observations still stand and must be reflected in a fair and sensible scheme:

(1) Government deposit insurance, which in Cyprus was EUR 100,000 per deposit, needs to be honored, but at the expense of the government, not the other depositors! Why would it be called a government scheme otherwise? In other words, the deposit insurance must explicitly, and in advance, include terms for depositor bail-ins, so that savers can act accordingly in advance, and governments, regulators, and courts can act fast in the event of a bank restructuring.

(2) Unconditional lower bounds on government deposit insurance (like the EUR 100,000 in Cyprus) create dangerous incentives, insofar as the rational behavior is to split money into as many deposits as necessary to not get above the limit, starting with the worst-rated banks where the depositor can get the highest interest rates. For example, if there are three banks, one paying 8% p.a., one paying 5%, and the other 0%, and you have, say, EUR 150,000 to park in accounts, you deposit 100,000 in the one paying 8% and 50,000 in the one paying 5%. Your money is then as safe as a government bond, but you earn a much higher yield. This is bad finance for the governments and/or the community at large which has to bail you out (either with their taxes or their deposits).

(3) We can’t make a distinction between types of depositors, as was the case in Cyprus, where insurance companies and banks, as well as others, were exempted from the haircut. That should be self-evident. Note, however, that we can make a distinction between depositors who hold collateral against the default risk (and therefore receive a very low rate of return), and those who do not. This distinction would presumably have included most deposits of banks and insurance companies anyway, and those who did not ask for collateral should unquestionably have been hit with a haircut.

(4) It would be good if we could distinguish between locked long-term savings, enjoying a very high interest rate over an extended period of time in exchange for liquidity constraints, and liquidity management accounts where businesses simply manage their day-to-day cash-flow, with no intention of “investing” the money for the long term. Operating capital for businesses (which very often receives no interest at all), should enjoy a higher degree of protection. If you think this is unfair, the Cyprus experience proves that it is nonetheless in the common interest to protect real businesses who just need to park their daily liquidity requirements. Businesses who pay for the payment management function of banks, without the need of a high return, need a “safe” environment to handle their payments in, or else the whole economy goes into a nosedive.

(5) The EU, under various proposals for its banking union, is debating an EU-wide deposit insurance scheme, funded by contributions from banks to a central insurance fund, similar to the ones operating for exmaple Germany and Austria already. My considered view is that such a scheme should not operate unconditionally. There has to be a dis-incentive for savers to simply seek the highest interest rates available without regard for the creditworthiness of the institution they bank their money with.

So I put it out there, as a first-cut, rough idea:

What if the deposit insurance explicitly applies a haircut as a fixed multiplier of the interest rate the account has enjoyed over the last years?

Imagine: Say the deposit insurance states explicitly that you can lose ten times your annual interest if your bank gets restructured. Would people indiscriminately seek high interest rates? Would they seek security instead? Does it matter what each one does? No! What matters is they have a choice between the two, and they know the potential consequences in advance. They have to, and can, make a considered decision between risk and return.

Business would go for zero-interest cash-management accounts as far as their daily payment management accounts are concerned, and their money would be fully protected. Those who go for high interest rates should be treated as savers, with part of their money (in proportion to the return) at risk. Banks and insurance companies have the same choice: Do I go for collateralised loans/deposits, enjoying high protection through the collateral, but yielding a low interest rate? Or do I take the risk (and the damage in case of default)?

Of course I can think of practical difficulties with my proposal (for example, how do you check what average rate was received when the money was moved around a lot?), but it does solve all the five major points above. Moreover, it leaves the governments (or central funds) on the hook for exactly what they have insured, and leaves the depositors on the hook for something they have been told in advance.

There is a safer, better, and more honest way to deal with deposit insurance than was done in Cyprus. This proposal is simple in principle, easy to understand for savers, creates the right incentives, and protects both the insurance fund/governments and depositors against unknown unknowns. The EU proposal must solve the five points above, and if there is a simpler proposal still, I will welcome it.

 

[1]

The Central Bank of Cyprus Blunders… and Plunders (Apr 2, 2013)

Interesting Deal For Cyprus (Mar 25, 2013)

The Final Minutes: Countdown in Cyprus (Mar 24, 2013)

A Crazy Thought (?) on Cyprus (Mar 21, 2013)

Breaking News: EU Statement on Cyprus (Mar 21, 2013)

Hot Or Not? Rumors of Cyprus’ next Move (Mar 20, 2013)

Cyprus, Round Two (Mar 19, 2013)

Cyprus: The State Giveth, the State Taketh Away (Mar 18, 2013)

 

One response to “A New Road-Map for Deposit Insurance

  1. My only concern with the proposal of a multiple-of-interest being the haircut is that this will lead to lower-rated banks sliding down the scale to default more quickly. If I am a weak bank, so I offer 4% rather than 2% on savings, there is now an extra cost for the saver that I need to compensate them for. So, I need to offer (say) 5% rather than the 4% that I would offer if these deposits were on equal terms with a bigger bank. This weakens the weak.

    Or the opposite could happen. Savings could become a weird kind of Giffen good, in which lower rates attract higher deposits. So if you’re a weak bank, you actually might be the one offering the cash-management services at 0% since that’s cheap money to you…and clients won’t care if you go bust since there is no haircut if you do.

    I don’t like the idea of linking the cost of money to the cost of government insurance in this way. Maybe we ought to instead think about this as insurance per se. You buy an insurance policy from the government in the form of a small tax on the account. What tax level you pay is determined by the usual insurance variables, including your “deductible” and the “lifetime cap” as well as the riskiness of your behavior. You can go to any bank you like, but if you go to a risky bank for a higher yield, you might want to have a high deductible since otherwise the insurance will be quite expensive. (In this case, the deductible is a FIRST LOSS piece, but you could get a $0 deductible and full coverage for ALL your deposits if you wanted).

    In fact, I sort of like that idea. Let’s start that company!

    Like

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