Cyprus: Deposit insurance and moral hazard

The outcry over Cyprus levy on depositors in defaulting banks raises the question: Why were depositors not more wary of where they deposited their funds? Not all banks are created equal. The reason is deposit insurance for deposits under €100,000 implied that the government would stand behind its banks and rescue depositors should the banks ever default. The problem is that no one considered the possibility that all the banks would suffer losses sufficient that the government would be forced to default on both its explicit and implied obligations.

Some time ago I wrote about the moral hazard of deposit insurance:

Deposit Insurance: When too much of a good idea becomes a bad idea

Deposit insurance was introduced in the 1930s and saved the US banking system from extinction. Administered by the FDIC, and funded by a levy on all banking institutions, deposit insurance, however, encourages moral hazard. Depositors need not concern themselves with the solvency of the bank where they deposit their funds so long as deposits are FDIC insured. High-risk institutions are able to compete for deposits on an equal footing with well-run, low-risk competitors. This inevitably leads to higher failure rates, as in the Savings & Loan crisis of the 1980s.

The FDIC does a good job of policing deposit-takers, but no regulator can substitute for market forces. Deposit insurance is critical during times of crisis, but should be scaled back when the crisis has passed. Either limit insured deposits to say $20,000 or only insure deposits to say 90% of value, where the depositor takes the first loss of 10%. That should be sufficient to keep depositors mindful as to where they bank. And restore the competitive advantage to well-run institutions.

Requiring depositors to take the first loss of 10 percent should be standard practice for deposit insurance. The same should hold true for bank creditors. But we need to distinguish between insolvency — where liabilities exceed assets — and a liquidity event where the central bank is only called on to provide temporary respite. If the bank is rescued from insolvency by the regulator, bond holders should be required to take an equivalent haircut — painful yet not life-threatening. No one is entitled to a free ride. And bank shareholders, if a there is a bail-out, should lose everything — similar to the Swedish approach in the 1990s.

10 Replies to “Cyprus: Deposit insurance and moral hazard”

  1. Wow! The banks are debtors of the depositors. Hence, deposits are liabilities of the banks. Our FDIC system works well. Weak banks fail because of poor management practices their creditors i.e. the depositors, have their choice of withdrawing all their money up to the FDIC limit or having their deposits moved to a stronger bank. I think you are way off base by suggesting depositors take a hit for the hubris of their banks.

    1. Depositors need to be wary of poorly-run and under-capitalized banks. If not, because of the implicit government guarantee, we are creating an incentive for banks to take risks: they get the rewards and the taxpayer carries the risk.

      Limiting the haircut to 10% would be sufficient to focus market attention on which banks are risky and which are not. That is how a free market works: rewarding good — and punishing bad — behavior.

      1. Colin, I do not follow nor understand your reasoning. I deposit to a bank in exchange for services and interest. They give me a precious little interest to use my money. If I wanted to have an interest in the bank I would buy stock. That’s where I get punished for bank losses or rewarded for bank gains with the stock value. Allowing the bank to “give me a haircut” is 1) rewarding them for bad behavior and 2) treating me like a stockholder. Sounds like a case of having their cake and eating it too!

      2. Hi Judy, We reward bad behavior by allowing banks that take big risks to attract deposits at the same interest rate as well-run competitors — because of the government guarantee. Banks should be rated according to their risk profile and badly-run banks should find it expensive, if not impossible to attract deposits. I do not want depositors to lose money — just to choose a bank with a high rating (not necessarily the biggest) to deposit with. Now rating agencies can get it wrong, but if the press and the public are constantly scrutinizing banks actions it will keep them honest. It also won’t take banks long to figure out the new rules: minimize your risks and maximize your profits: through lower funding costs and lower write-offs.

  2. Colin
    Banks dont start out being undercapitized , it is caused by the risky behavior from bank employees who’s reward come without risk to them personaly.
    How about we have a set of rules that pay a basic office wage to the traders , with thier bonuses linked to the net income on the trade.

    It is time to go back to the way people thought it worked and that is the deposited money is lent against an asset of a greater value.

    Bottom line is, even Allan Greenspan finaly admitteed that the market can not regulate itself.
    I think we should send thoes adrenalin pumped traders of to the funny farm.

    1. Banks should not be allowed to take overnight positions in the market. That means you can buy and sell during the day but have to close all your positions overnight. No longer-term risk while backed by the taxpayer’s dollar. If you take overnight positions, you lose your banking license.

  3. Colin: The correct principle is to follow the legally stated capital structure. In the U.S., the damage should flow in the following order: (1) equity, (2) preferred equity, (3) junior/sub debt, (4) unsecured debt including all deferred compensation claims of bank executives and retirees and deposits above deposit limits, (5) secured debt, (6) depositors (up to deposit limits). You cannot find the Cyprus situation acceptable given that the above hierarchy or its equivalent in other countries have been routinely flouted in favor of the wealthy and politically connected. The uproar with Cyprus is not that depositors were hit with losses, but that those losses were not allocated first to junior debt and then uninsured deposit balances (due to fear of implications with Russia).

    1. “The uproar with Cyprus is not that depositors were hit with losses, but that those losses were not allocated first to junior debt and then uninsured deposit balances….”

      The headlines are a lot shorter — most along the lines of “Cyprus grabs bank deposits”.
      My point was that depositors should not expect an automatic bail-out and not in support of the bail-out structure, which was ridiculous.

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