March 23, 2013

There’s a Reason for Deposit Insurance



FOR all the criticism of bailouts since the financial crisis struck, virtually no one has suggested that depositors in banks be made to suffer along with their investors, employees and customers. Until this week, when the euro zone proposed that, in return for a bailout of the failing banking system in Cyprus, depositors pay a “tax” of 6.75 percent of their deposits 9.9 percent for deposits above 100,000 euros.

Because bank deposits in Cyprus, and virtually everywhere, are insured, the plan shocked many people who figured that this insurance was the one financial safety net that was still truly “safe.” 

The Cypriot Parliament shot down the plan, though a smaller hit to depositorsmany of whom are wealthy foreigners — was still in the offing late last week. Yet the tempest in the eastern Mediterranean is a reminder that depositors, in fact, are also creditors of banks and are potentially at risk.

In the United States, deposit insurance is viewed as sacrosanct. But even here, such plans haven’t always worked, and at least until recent times they have been contentious.

If the nation has a father of bank insurance, it is Joshua Forman, one of the promoters of the Erie Canal. Early in the 19th century, New York State had a string of bank failures, and Martin Van Buren, then governor, asked him to restructure the banking industry.

Forman’s insight was that banks were vulnerable to chain-reaction panics. As he put itin a line unearthed by the Harvard Business School historian David Moss — “banks constitute a system, being peculiarly sensitive to one another’s operations, and not a mere aggregate of free agents.”

In 1829, Forman proposed an insurance fund capitalized by mandatory contributions from the state’s banks. Debate in the State Assembly was heated. Critics said failures could overwhelm the fund; they also argued that its very existence would reduce the “public scrutiny and watchfulness” that restrained bankers from reckless lending. This remains the intellectual argument against insurance today. But Forman’s plan was enacted, and subsequently five other states adopted plans.

All did not go smoothly. In the 1840s, during a national depression, 11 banks in New York State failed and the insurance fund — as prophesied — was threatened with insolvency. The state sold bonds to bail it out.

After the Civil War and the establishment of nationally chartered banks, the state insurance systems were allowed to die. But banking panics and money shortages in the 1870s and ’80s revived the issue. Republicans thought the way to stop panics was to establish a central bank.

Democrats were inveterate central-bank haters, but they needed a solution. William Jennings Bryan, the party’s three-time presidential nominee, called for deposit insurance, especially to protect small depositors.

Bryan lost the elections, but he won a victory of sorts on insurance. In 1907, a Wall Street panic led to a depression, and banks nationwide resorted to doling out scrip rather than cash.

With the economy still in free-fall, Oklahoma adopted deposit insurance. Republicans were hotly opposed. President William Howard Taft, running against Bryan for president in 1908, said the Oklahoma lawput a premium on reckless banking.” The industry predicted that the system would fail. Depositors, argued James Laughlin, a banking expert of the day, should rely on the “skill, integrity and good management” of bankers.

Oklahomans thought otherwise. So great was the demand for insurance that Oklahoma banks with national charters liquidated and reorganized as state banks to participate. In fact, people in neighboring Kansas began to deposit in Oklahoma, forcing Kansas to enact a similar plan. Ultimately, eight states adopted insurance.

Their experience, alas, bore out the critics’ warnings. Depressed farm prices led to waves of bank failures in the 1920s, and one by one state systems folded.

When bank failures reached epidemic proportions in the Great Depression, the idea was revived. Again, the industry opposed it — as did Franklin D. Roosevelt, who said insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor.” Insurance was to be financed by premiums from banks. Still, because it was guaranteed by the government, Roosevelt feared that it could bankrupt the Treasury.

But popular opinion prevailed. The Federal Deposit Insurance Corporation was created in 1933, protecting deposits up to $2,500. Over time, the insured limit rose to $100,000. (And it more than doubled, to $250,000, in the recent crisis.)

The system worked — for a while. In the 1970s, finance was deregulated, interest rates turned volatile and savings and loan associations (protected by another agency) took huge risks. Hundreds of S.& L.’s failed, and their insurer became insolvent. Taxpayers had to fork over more than $100 billion.

To critics, the S.& L. fiasco proved that insurance was a flawed concept. The problem wasn’t insurance per se, but that premiums weren’t high enough — nor were they adjusted according to the risk presented by individual banks. (By the same principle, any rational auto insurer will charge a higher premium for an 18-year-old with a D.U.I.)
INCREDIBLY, Congress didn’t learn its lesson. After recovery from the S.& L. crisis, Congress, lulled by an improving climate, succumbed to bankers who called the F.D.I.C. overfinanced. Premiums were cut to zero for banks judged to be well capitalized.
Again, the good times didn’t last. In 2009, in the financial crisis, the F.D.I.C. fund was underwater.

Net assets$53 billion before the crash fell to a negative $21 billion. The agency crawled back into the black by ordering banks to pay premiums in advance and by leveling a special assessment. In 2010, the Dodd-Frank law raised premiums, especially for bigger banks and for banks classified as riskier. No taxpayer money was used.
The F.D.I.C.’s deficit amounted to a failure of foresight, or courage, by Congress, but the system succeeded in the larger sense of heading off panics. Just imagine the crisis in confidence in 2008 had ordinary depositors feared for their money. Insurance proved to be worth its weight in gold.

Cyprus, alas, does not have the option of a national government bailout because it does not print its own money. Even if it rejects the euro zone’s terms and bails out banks in some new local currency, that currency would not be worth much in international markets. So one way or another, its depositors are going to lose. Insurance plans are just as safe — but cannot be any saferthan the assets behind them.
Roger Lowenstein is writing a book on the origins of the Federal Reserve.

The eurozone after Cyprus

March 24, 2013 1:55 am

by Gavyn Davies


The calmness of the financial markets in the face of the deteriorating Cyprus crisis in the past week has been remarkable. Although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone.

Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis, if a microcosm on steroids. The manner in which the crisis has been handled by the Eurogroup and the ECB will have demonstration effects on other economies, for good or ill.

At the time of writing, the outcome of this weekend’s negotiations remains uncertain. However, assuming that there is no catastrophic breakdown in the talks, leading to the exit of Cyprus from the euro area, the broad outline of the settlement seems to be taking shape. It is reported that the Cypriot government will accept a “bail in” of depositors in one or both of its troubled banks, allowing the release of eurozone financial support, while still keeping the government debt/GDP ratio under 150 per cent.

Furthermore, the banking sector should be sufficiently cleaned up and recapitalised to allow the ECB to release further Emergency Lending Assistance from the central bank of Cyprus next week, thus enabling the banks to re-open. Many large depositors would find themselves subject to painful haircuts, rumoured to be around 33 per cent, and then locked into equity in the “bad bank” which would be created by the bank restructuring.

Controls would be imposed on the free movement of capital, so these large depositors, many of them Russian, would be unable to withdraw their remaining funds for an indefinite period. If the Cyprus Parliament baulks at these terms, which is still not impossible, then the spectre of an early exit from the euro would once again begin to loom into view.

A deal of the sort outlined above, keeping the euro intact, would probably be enough to prevent any immediate contagion effects to other economies. After all, everyone knows that Cyprus is a special case, given the size of its banking sector relative to GDP, its exposure to foreign depositors of questionable virtue and its concentration of bank lending to the collapsed Greek economy.

No other economy has that combination of disadvantages, which has made a conventional bank rescue impossible for the Cypriot government, and unacceptable to the rest of the eurozone, especially Germany. Bank depositors in Spain and Italy will presumably be aware of these unique features, and therefore more willing to view it as a special case.

That said, four of the features of the reported deal are setting unfortunate precedents for the future.

First, the way in which the bank failures have been handled shows that the eurozone is still very far removed from a workable banking union. The original rescue plan last weekend made the cardinal mistake of requiring a haircut on small depositors of under €100,000, who could reasonably have expected protection from losses. It is a well established principle of bank work-outs that losses should be taken in the following order: shareholders first, then bondholders, then uninsured depositors, then insured small depositors. The fact that the Eurogroup was willing even to contemplate anything different sends a very bad signal, though hopefully the worst has now been avoided.

Second, the principle of divorcing the debt of governments from that of banks (and thus breaking the “diabolical loop” which threatened to bring down Spain last year), was very rapidly thrown out of the window in Cyprus. There was apparently no willingness to use ESM money directly to recapitalise the banks, even though that is being done successfully with the Bankia resolution in Spain this very week.

German Finance Minister Schauble even went as far as to say that in other countries small deposits are safeonly on the proviso that the states are solvent”. Does that not drive a coach and horses through the separation of banks and governments, which was one of the principle promises made by eurozone leaders at their crucial summit of June 29, 2012?

Third, there is the possibility that investors will view any haircut on large depositors not as a special tax, or a bail in of creditors, but as a capital levy on investors. What is the difference, one might ask? A capital levy occurs when governments require their citizens to contribute to state finances by paying a percentage of their wealth to the government. The theory is that, if this is done without warning in extraordinary circumstances, and as a once only event, it allows revenue to be raised without having the usual disincentive effects on work effort and savings.

Barry Eichengreen’s fascinating analysis of the history of capital levies argues that they will inevitably be considered when governments get themselves into severe debt crises, though he adds that they are hard to apply in democracies, and are rarely successful. It would be most unfortunate if investors in the euro area began to fear that capital levies of this sort might come onto the agenda if the crisis gets worse. A flight of capital could result. (See alsoCyprus Levy: Historical Precedents” by Carola Binder.)

Fourth, there is the fact that direct controls over the exit of capital from a eurozone member will have occurred for the first time in Cyprus. This replicates what happened in the Icelandic bank crisis, when capital controls were originally said to be temporary, but have proven impossible to remove ever since.

But to have this happen within the borders of a “single currency” is a different matter. Indeed, it seems to breach one of the basic principles of a single currency in the first place. (See Jeremy Warner.)

If the reported deal is done to keep Cyprus inside the euro by Monday, we can expect to hear, very loudly, that this is a unique case, and that the unfortunate features of this settlement cannot be extrapolated to any other future circumstances. Let us hope not. If nothing else, it would certainly demonstrate that the eurozone still has much work to do before the crisis is fully under control.

Mario Draghi’s Opiate of the Markets

Luigi Zingales

22 March 2013

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CHICAGOFrom the standpoint of European stability, the Italian elections could not have delivered a worse outcome. Italy’s parliament is divided among three mutually incompatible political forces, with none strong enough to rule alone. Worse, one of these forces, which won 25% of the vote, is an anti-euro populist party, while another, a Euro-skeptic group led by former Prime Minister Silvio Berlusconi, received close to 30% support, giving anti-euro parties a clear majority.
Despite these scary results, the interest-rate spread for Italian government bonds relative to German bunds has increased by only 40 basis points since the election. In July 2012, when a pro-European, austerity-minded government was running the country, with the well-respected economist Mario Monti in charge, the spread reached 536 basis points. Today, with no government and little chance that a decent one will be formed soon, the spread sits at 314 points. So, are markets bullish about Italy, or have they lost their ability to assess risk?
A recent survey of international investors conducted by Morgan Stanley suggests that they are not bullish. Forty-six percent of the respondents said that the most likely outcome for Italy is an interim administration and new elections. And they regard this outcome as the worst-case scenario, one that implies a delay of any further economic measures, deep policy uncertainty, and the risk of an even less favorable electoral outcome.
The survey also clearly indicated why the interest-rate spread for Italian government bonds is not much wider: the perceived backstop provided by the European Central Bank. Although investors believe that the backstop is unlikely to be used, its mere presence dissuades them from betting against Italy. In other words, the “outright monetary transactions” (OMT) scheme announced by ECB President Mario Draghi last July has served as the proverbialbazooka” – a gun so powerful that it does not need to be used.
Then-US Treasury Secretary Hank Paulson sought a bazooka during the 2008 financial crisis. He failed, because he believed that even a fake gun would work if it looked scary enough. Not falling for the trick, speculators repeatedly called his bluff.

Draghi, with his famous pledge to do “whatever it takes” to ensure the euro’s survival, succeeded where Paulson did not. After all, he controls the monetary spigot.
But even Draghi’s bazooka is partly a bluff. Draghi designed it to relieve the ECB of the huge political responsibility of deciding when to save a country from default. For this reason, triggering the OMT mechanism requires the unanimous consent of eurozone governments. But, if the bazooka is needed, how likely is it to be fired before the German election in September? The Morgan Stanley survey did not ask this question, probably because everybody knows the answer: not likely at all.
Thus, markets remain calm because they expect the bazooka not to be needed. In that case, the fact that it cannot be triggered easily does not pose a significant problem. Its presence is enough to support a benign self-fulfilling prophecy. In other words, Draghi’s bazooka has anesthetized markets, impairing their ability to assess risk.
But as with all anesthetics, Draghi’s cannot and will not last forever. Either the underlying problem is fixed before the patient wakes up, or the pain will be devastating.
The investors surveyed by Morgan Stanley put the chance of a renewed crisis in Italy below 25%. I believe that it is higher than 50%. Even after Germany’s election, I am not sure that the government will be willing to support an Italian rescue program without asking for major guarantees concerning the objectives – and even the composition – of Italy’s ruling coalition.
Indeed, German Chancellor Angela Merkel will face a serious dilemma following her likely re-election. Without strict conditionality, she would risk shifting the domestic consensus in favor of Germany’s emerging Euro-skeptic mood. But, by insisting on such conditionality, she would trigger a huge political crisis in Europe.

If the German government gets to decide who governs Italy, why should Italians bother voting? The eurozone will look like a German protectorate, rather than a voluntary union of sovereign countries. The political backlash would be enormous.
The only hope is that the eurozone makes strong progress toward establishing fiscal-redistribution mechanisms, such as European unemployment insurance, before Draghi’s anesthetic wears off. Otherwise, Europe will face a very rude awakening indeed.

Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, and serves on the Committee on Capital Markets Regulation. He is also a faculty research fellow at the National Bureau of Economic Research, a research fellow at the Center for Economic Policy Research, and a fellow of the European Governance Institute. He is the author of A Capitalism for the People: Recapturing the Lost Genius of American Prosperity

March 24, 2013 6:29 pm
Eurozone break-up edges even closer
Cyprus is a perfect illustration of the way the region struggles with collective action
In the past eight months before Cyprus erupted people have frequently reminded me, often with a smirk, of a forecast I made in late November 2011. On these pages, I declared that eurozone leaders had 10 days to save the euro. I made an ultimately similar, though less dramatic, prediction in 2006 when I wrote that Romano Prodi’s administration offered Italy’s last chance to achieve a sustainable position in the eurozone.

Mr Prodi’s administration did not deliver. The 10 days in 2011 passed without action. It is 2013, the euro is still there, Italy is still in it – and I am still making forecasts. Undeterred, I will double down today. A eurozone that compromises countries as diverse as Germany and Cyprus is not sustainable, even if the EU and Cyprus manage to find a last-minute compromise. An operational banking union that comprises supervision, resolution and deposit insurance would have been a minimally sufficient condition to make a divergent monetary system work against the odds. It would have solved the problems of the Cypriot banks for sure. But the eurozone does not have such a banking union. It will not have such a banking union in five years. Germany rejects it flat out on the grounds that it is too expensive for the German taxpayer.

Ironically, Cyprus would also reject it as it would kill the country’s business model as an offshore centre for foreign deposits. Whatever banking union will ultimately emerge in the long run will be irrelevant to this crisis.

What happened in Cyprus last week is not a deep cause of anything. But it is a perfect illustration of the eurozone’s collective action problem. This latest escalation began with the dangerous agreement to bail-in insured depositors. Eurozone officials are as legally literate as they are economically illiterate. Their ever so brilliant idea was not to haircut insured deposits of under €100,000, but simply to tax them. They did not realise that if they take away the promise inherent in deposit insurance, they are in default, and in danger of starting a bank run.

The Cypriot parliament was right to reject this mad deal. But the Cypriot government then committed three subsequent blunders. The first was the decision by President Nicos Anastasiades to seek help from Russia. Instead of working with the eurozone, he worked against it. The Germans, in particular, saw this as an openly hostile move. It was also ill-judged because the Russians rejected the offer. The second was the decision not to communicate with the European finance ministers and the euro working group for three critical days last week. The third was the Cypriot government’s proposal on Thursday to create a sovereign wealth fund backed by a raid on the pension fund and other state assets. On Friday Angela Merkel swiftly dismissed it.

What happened last week is a fitting example of European political leaders, in a most unprofessional pursuit of narrow national interests, failing to defend the common good.

The main risk I want to emphasise is, however, not a big accident. It might happen, of course. But I suspect the single biggest risk ultimately stems from the eurozone’s repeated policy errors. Their effect is slow but cumulative.

Of those, the most damaging has been the policy of asymmetric adjustment through austerity. Banks in Cyprus are falling now because the Greek state and Greek banks fell earlier, and because the eurozone forced a private-sector involvement. In Italy, it was also austerity that turned a recession into a depression. That, in turn, transformed an anti-euro, anti-establishment protest movement into the single largest political party in the Italian parliament at the last elections. There is a good chance that its leader, Beppe Grillo, could end up with an absolute majority if Italy were to hold another round of elections later this year.

If austerity in the south had at least been compensated by fiscal expansion in the north, the overall fiscal stance of the eurozone would have been macroeconomically neutral. But since the north joined the austerity, the eurozone ended up with a primary fiscal surplus in a recession. In such an environment, economic adjustment simply does not take place. Without that, there can be no solution to the crisis.

I have believed for some time that it is impossible for Germany, Finland and the Netherlands to be in a monetary union with Cyprus, Greece and Portugal. Either the two sides agree to adjust more symmetrically, politically and economically, or this experiment should end.

The prediction I made in November 2011, and which I am repeating today, is that it will probably end one day, though that day may still be a long way off. I cannot exclude the possibility that the various governments will do the right thing, but three years of crisis management suggest otherwise.

With the current policy, they will need force to keep it going against the interests of the people. You do not need to be a eurosceptic to conclude that such a monetary union is also deeply immoral.

Copyright The Financial Times Limited 2013.