ALMOST all concerned agree that the Cypriot scheme for converting depositors into bank shareholders was mishandled – bondholders should not have been spared; the scheme should not have taken the form of a tax; if the EU deposit insurance threshold of €100,000 (£85,600) is too high (it is), it should have been reduced, not ignored. The plan has now been rejected by Cyprus’s parliament.
But setting aside the politics and ineptitude of the Cypriot scheme, what of the general principle of imposing losses on depositors in bust banks? For many commentators and lay people, it is this aspect of the Cypriot scheme that was so shocking: they regard the money they deposit in banks as their savings and regard it as little short of theft for there to be any deduction from those savings.
It’s an understandable attitude, but simply incorrect. A deposit in a fractional reserve bank (the ordinary high street banks we have in Europe) is a loan the depositor makes to the bank – deposits are not, in that sense, “savings” at all. The depositor receives interest on the loan (the deposit) precisely because the bank uses deposits to support risky lending of its own – lending for mortgages, business finance, personal loans, and so on.
If the bank fails, it cannot repay all of its loans. If the failure is sufficiently severe, that should mean depositors, also, lose out in some way – that was, after all, why they received interest on the loans they made to the bank. Under most circumstances it should work like this: if you loaned money to a chip shop and it went bust, you would own a chip shop, so if you loan money to (deposit funds in) a bank and it goes bust, you should own a bank. Your deposits should be converted into equity (as per Cyprus).
There are those that say this is unfair and inconceivable, since ordinary depositors cannot understand bank balance sheets. Well, the answer to that should be quite simple: if you don’t understand complex bank balance sheets and can’t find a simpler bank that you do understand, then don’t lend your money to (don’t put your deposits in) a fractional reserve bank! We got along fine in the UK with no deposit insurance until 1979.
But if you don’t deposit your money in a fractional reserve bank, what should you do with it? Keep it under the bed? No. There are other forms of banking than the fractional reserve banks common today. Until the mid-1980s there were “savings banks” (like the old TSB), which simply stored your deposits in the form of government bonds, gold or cash – deposits were “100 per cent backed”, in the jargon. This form of account was driven out, inter alia, by deposit insurance. We could bring it back by requiring all banks licensed to accept retail deposits to offer a form of ring-fenced 100 per cent-backed, 100 per cent-insured “storage deposit” alongside uninsured fractional reserve “investment deposits”.
We can only have a healthy banking sector if bailouts are ended and bank creditor insurance is removed. That means depositors as well. I hope the botched Cypriot scheme has not undermined this important principle.
Andrew Lilico is chairman of Europe Economics.