Why banking needs to be safer and riskier at the same time

Allister Heath
CYPRUS is bound to quit the euro. That, at least is the verdict of Charles Dumas of Lombard Street Research. He fears that the shrinkage of Cyprus’ banking system will lead to a slump in incomes and a debt-deflationary spiral, confronting the country with a Hobson’s choice between sudden death by execution or a lingering one by starvation.

But regardless of whether the tiny island does eventually quit, or whether the single currency stumbles on until eventually an even greater disaster sends the whole rotten edifice crashing down, the more pressing question is what happens to banks in other parts of region.

Are uninsured deposits (those larger than €100,000) at risk if banks go bust – I agreed yesterday that yes, sadly, they should be, as we must now play by the rules and reduce moral hazard – or are they not?

Officials are making contradictory noises in a bid to reassure nervous Southern European countries. But the reality is straightforward, and is already enshrined in law. Since June 2012, the EU Bank Resolution Directive has specified that there would be the possibility of bail-ins – in other words, losses in return for equity in the bank – for large deposits in the event of failure. However, a range of other investors and creditors would be hit first. The first losses would be borne by shareholders; then bondholders; and only then people with uninsured deposits.

The document also states that “where deposits are transferred to another institution in the context of the resolution of a credit institution, depositors should not be insured beyond the level of coverage provided in Directive 94/19/EC [i.e. around £85,000]”.

So could other depositors be hit in Southern Europe, as they just have in Cyprus? Bank of Cyprus’s assets were funded 77 per cent by deposits, 13 per through wholesale and only three per cent by debt. Equity was just six per cent. It was inevitable, therefore, that – in the absence of a direct bailout of the institution – depositors would participate in the recapitalisation, as even a full conversion of debt to equity would have been insufficient. Spain and Italy are different: funding is more balanced between deposits and debt, so there is much more loss-absorbing potential than in Cyprus. Barring a sovereign default, depositors are likely to be safer

Yet we need a new way of ensuring greater security for savers. Many would prefer to have the option, for a fee, to put cash in special accounts and be certain that they would never lose anything.

The only way to ensure this is to ask banks to start providing vault-like facilities (at a cost, and paying no interest) on top of the usual interest bearing fractional reserve deposits. These storage accounts – an idea developed by Europe Economics’ Andrew Lilico – would be backed by secure assets, such as gilts (assuming they are safe enough).

They would work like segregated accounts and their contents would be the depositors’ property; the money in them could not be used for anything else or be lent out and would thus be recoverable if a bank went bust. At present, deposits in bank accounts are legally loans to the bank.

Savers willing to take risk would still use traditional bank accounts, though we also need commercial pricing of deposit insurance, with higher premia for riskier banks. We need to re-inject capitalism into banking, with depositors needing to be made aware that they too could lose out in extremis – but that will only work if savers are given the option to pay for a truly safe abode for their cash, if that is what they genuinely prefer.