Tuesday, March 19, 2013

Deposit insurance in Cyprus

It looks like it is still undecided whether or not insured deposits in Cypriot banks will have to take a haircut before the ECB writes a check to Cyprus. Matt Yglesias gets both the financial mechanics and the politics complete wrong though. He says:
“Bank creditors,” as it happens, is a class of people that includes bank depositors. Everything about the rhetoric of banking is designed to obscure this. You deposit money in your bank account and you can go online 24 hours a day and check how much money is in there. But what you’ve really done is loaned the money to the bank, and the bank has promised that it’ll repay your loan. If the bank takes the money it’s been lent and squanders it on bad investments, then you’re going to be in need of a bailout if you want to get your money back. When the FDIC guarantees your bank deposit, it is essentially saying it will bail you out if your bank fails.
This is false. Banks do not lend out deposits, they create loans out of thin air, leveraging up their capital base. Equity holders, and those who have bought commercial paper in the bank are creditors. Depositors are not. FDIC insurance is a partial recognition of this reality, and unlimited FDIC insurance would go a long way to making the financial industry more sane. It may also kill the money market fund, which is a feature, not a bug.
A modest amount of deposit insurance is a socially useful way to let regular people have secure bank accounts without becoming experts in bank supervision. But the willy-nilly extension of the principle—insuring all depositors up to any amount—leaves banks overindebted and underdisciplined.
No. Poor capital controls, securitization, and an unwillingness support an economy through fiscal expansion is what leaves banks overindebted and underdisciplined.

I'm sure the EU bail out plan came with all manner of austerity rules that Cyrpus didn't like, so they included the insured depositor haircut as a poison pill to scuttle the whole thing and renegotiate from a position of strength.

A fiat currency is an extension of sovereign power, and the Euro has established the currency without the sovereignity. Germany and the ECB are walking a tightrope now, using the pain they can inflict as currency issuers to exert power of other European countries. Those countries can exert their sovereign power by opting out of the whole arrangement, so the pain cannot be too deep, but this is the essential dynamic at play.

And even if Cyprus did opt out, what's its next step? As Yglesias notes, it's a very small country with about 1M people. There is a reason it is an offshore haven for Russian money.


Blogger Ralph Musgrave said...

“Banks do not lend out deposits, they create loans out of thin air….” Not true. It’s certainly true that a bank can lend a LIMITED AMOUNT of money into existence or “out of thin air”. But it cannot race ahead of other banks in that regard, else it runs out of reserves.

In fact over the last two years or so, and thanks to deleveraging etc, the commercial banking system AS A WHOLE has created virtually no extra “thin air” money. That’s in stark contrast to the years just prior to the crunch when the “system” was lending money into existence like there’s no tomorrow.

In short, banks HAVE TO attract deposits. I.e. when a bank’s deposits rise by $X, it can then lend approximately another $X. So in effect, banks are to a large extent in the business of lending out depositors’ money.

“Poor capital controls, securitization, and an unwillingness support an economy through fiscal expansion is what leaves banks overindebted and underdisciplined..” No.

Obviously inadequate fiscal expansion doesn’t help. Plus it’s obvious that if the amount of capital that banks had to hold was doubled from the existing miserable 3% suggested by Basel III that that would make banks safer. But even having done that, there is nothing in principle to stop a bank going bust.

Indeed, in the case of the most disastrously run small banks which fail at the rate of about one a week in the U.S., assets turn out to be worth HALF their liabilities. I.e. even insisting that banks held capital to the tune of 50% of their assets would not save every bank.

There’s actually a book just been published and reviewed in the Financial Times yesterday by Martin Wolf, which argues that banks should have capital ratios of 20-30%. See:


12:39 AM  
Blogger winterspeak said...


Banks run short of reserves all the time. It is because some banks end the day short reserves, while others end long reserves, that there is an overnight interbank reserve lending market at all. This is how the Fed sets interest rates, and is an integral part of the current system design.

Don't confuse reserve requirements with capital requirements.

9:41 AM  
Blogger marris said...

I think Ralph's characterization is accurate. A bank that races ahead and issues shoddy loans is a big credit risk. They wouldn't easily get these reserves, and would probably fail (with FDIC unwind).

3:00 PM  
Blogger winterspeak said...


I think you might be getting it backwards.

A bank that races ahead and issues shoddy loans is a big credit risk, in that it is undercapitalized for the its loan portfolio. This means that it falls short of its capital requirements, and is insolvent for that reason.

The reserves stop flowing because the bank is short on capital.

1:13 PM  

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