Giving bank depositors 'haircuts' sets a bad precedent


People walk past a branch of Bank of Cyprus in Bucharest March 25, 2013.

Article Highlights

  • We are not yet out of the heat of the crisis

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  • Banks in Spain and Italy are in urgent need of a quick resolution to the uncertainty of bank bail-ins.

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  • Let's be very clear: "bailing in" depositors is off the table.

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"Bailing in" implies the opposite of governments' "bailing out" careless investors or bank managers with public money. Specifically, "bailing in" substitutes appropriate losses by "at risk" investors for injections of taxpayer funds to rescue them. The recent collapse of Cypriot banks included "bail ins" for investors. But large depositors were also "bailed in", suffering the loss of at least 60 percent of their deposits. This was described as making investors pay for bad banking instead of taxpayers bailing out the banks.

But do we really want to treat bank depositors as "investors"? The Dutch finance minister, Jeroen Dijsselboem, now president of the Eurozone's foreign minister group, is a 46 year old agricultural economist who thinks that bailing in large depositors in Cypriot banks by expropriating at least 60% of their deposits was the right approach to March's Cypriot bank work out. As Mr. Dijsselboem said, "that's an approach we, now that we are out of the crisis, should consequently take."

Mr. Dijsselboem is going to find that we are not yet out of the heat of the crisis. Treating depositors as investors along with senior bond holders and equity holders of banks sets a dangerous precedent. How will Italian - not to mention British, American, and Canadian - households and firms respond to Mr. Dijsselbloem's message that holding deposits at a bank in order to effect transactions or briefly to store value makes them investors in the bank subject to a "haircut" in the event of a required bank bailout?

In 1933, when the Federal Reserve Bank refused to bail out the Bank of the United States, it triggered a run on American banks. The principal was the same. No bailout for depositors in bad banks. The result of a run on the banks was a collapse in the US money supply by a third. After all, bank deposits are supposed to be a part of the money supply used to effect transactions and store value over short periods of time. The collapse in the money supply resulted in an economic collapse that ultimately morphed into the Great Depression. Let's not even think about going there by using the Cyprus "template" for dealing with weak banks.

If the EU-ECB-IMF "troika", the gang that can't shoot straight, wants to subject all Euro depositors to "bail-in" they should say so. Then depositors in European banks and elsewhere can act accordingly. That is, rush into cash in times of real or perceived crisis in order to preserve their assets. That would constitute a run on Europe's banks, starting in Greece, then in Spain, Italy and Portugal and eventually reaching France, bank that would collapse Europe's money supply and its economy. The run and economic collapse would spread rapidly throughout the global economy.

What we really need to do is move as rapidly as possible back to a sharp dichotomy between depository institutions and investment banks. Call it a global return to Glass-Steagall if you like. Given the ongoing Cyprus bank fiasco, households and firms still need bank- issued money in order to effect transactions and carry on normal business and, now more than ever, to avail themselves of a safe, liquid, short-term store of value. They need to be spared fears of imminent "bail-ins" and deposit confiscation every time a crisis flares up in Europe or elsewhere.

If JP Morgan's "Whale" problem, essentially a blatant dodge of prohibition of running a hedge fund inside a bank and calling its activities "hedging" -pun intended- had blown up and jeopardized its solvency, would the Fed want to bail-in JP Morgan's retail Chase depositors? I don't think so.

Headlines notwithstanding, depositors and taxpayers are often the very same people. The Russian depositors in Cyprus may not be Cypriot taxpayers, but they are representative of a class of asset holders seeking a safe and liquid place to hold their funds. There are plenty of European, not to mention American, households and firms that are both depositors and taxpayers. The increased fear of surprise taxes on their deposits, "bail ins", resulting from the bungled Cyprus bailout is not helpful at a time when banking systems are fragile. Bank regulators need to move faster toward establishing depository institutions and labeling them clearly as distinct from investment banks where are no depositors but there certainly are bond and equity holders whose funds are at risk.

Banks in Spain and Italy are in urgent need of a quick resolution to the uncertainty of bank bail-ins. Within hours of his ill-considered March 26 comment on the Cyprus bailout, Mr. Dijsselboem was forced to back -track on his attempt to generalize the "bail in" of depositors in Cypriot banks by saying "no models or templates apply". The European Commission insisted that Cypress is not a template for Eurozone countries, read Greece, Spain and Italy, especially, but it prefers a restructuring program over using taxpayer's funds to save banks in trouble. Restructuring is fine but not if it includes destruction of a substantial portion of the money supply in the form of confiscation of deposits, be they insured or uninsured.

It's important to get back to basics. If banks are going to accept deposits that constitute a part of the money supply, a sharp contraction of which could cause a recession or depression, they need to be constrained to invest only in safe assets. Investment banks can thrive, but not with funds provided by depositors. They need to be subject to market discipline that could involve sharp losses by investors in those institutions as distinct from depositors in depository institutions.

A template that distinguishes between depository institutions and investment banks may help to resolve the "too big to fail issue" since a number of the largest banks would have to strip out either their depository or investment operation. In the meantime, let's be very clear, that "bailing in" depositors is off the table. Then, banks in Greece, Spain, Italy and the rest of Europe can breathe a sigh of relief while they strengthen their balance sheets and American banks can stop worrying about contagion risk.

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About the Author


John H.
  • John H. Makin is a resident scholar at the American Enterprise Institute (AEI) where he studies the US economy, monetary policy, financial markets, corporate taxation and banking. He also studies and writes frequently about Japanese, Chinese and European economic issues.

    Makin has served as a consultant to the US Treasury Department, the Congressional Budget Office, and the International Monetary Fund. He spent twenty years on Wall Street as the chief economist, and later as a principal of Caxton Associates a trading and investment firm. Earlier, Makin taught economics at various universities including the University of Virginia. He has also been a scholar at the Bank of Japan, the Federal Reserve Bank of San Francisco, the Federal Bank of Chicago, and the National Bureau of Economic Research. A prolific writer, Makin is the author of numerous books and articles on financial, monetary, and fiscal policy. Makin also writes AEI's monthly Economic Outlook which pairs insightful research with current economic topics.

    Makin received his doctorate and master’s degree in economics from University of Chicago, and bachelor’s degree in economics from Trinity College.

    Follow John Makin on Twitter.

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