Early banks were established by wealthy men that depositors could trust to return their money when they wanted it. Bank owners had unlimited liability for the trust placed in them. Any losses that exceeded what the bank owed its creditors (primarily depositors) had to be made up from the personal wealth of their owners.
With the introduction of limited liability banks, bank owners invested in significant amounts of capital (the difference between the value of the bank’s assets and liabilities) to reassure depositors that the bank was safe. They also advertised the conservatism with which they lent and invested depositor money. Some countries granted bank owners a liability limited to double the capital they paid into the bank in order to increase depositor protection without tying as much money up in capital. In the much of the nineteenth century in the United States banks held capital well above 50% of their loans.
These early experiences with banking without any deposit insurance or any expectation by depositors that someone would bail them out (repay their deposits) if the bank failed (failure was the result of the bank not having enough money to repay depositors), maximized the market’s discipline of bank risk taking. Depositors paid close attention to the safety and soundness of the bank they put their money in.
During the great depression, the U.S. and most other countries introduced limited deposit insurance for small depositors thought to be too unsophisticated to evaluate the soundness of their banks. Such deposit insurance pretty much eliminated bank runs by panicked depositors. The level of deposits covered by insurance has risen considerably in most places (in the U.S. it is $250,000 and in Europe €100,000) thus reducing market discipline to some degree.
But outside of the United States, where the Federal Deposit Insurance Corporation (FDIC) has broad intervention and resolution powers to take over insolvent banks and to keep them going (if that is the least cost resolution) by reducing shareholder, bondholder, and uninsured depositor claims, almost no country allows its banks to fail (though this has begun to change in the last decade or two). If a bank experienced large enough losses that it became unable to pay off its depositors (i.e. became insolvent), governments would almost always bail it out one way or another. Depositors never lost anything. This practice and the market expectation it created made a joke of limited deposit insurance (because ALL deposits were implicitly guaranteed) and significantly reduced market discipline of bank behavior. This required more active supervision and regulation of banks to take the place of market regulation.
After a very bad start in Cyprus last week (see my blog from last week: https://wcoats.wordpress.com/2013/03/23/cyprus-and-the-euro/) the resolution of Cyprus’ two largest banks, Cyprus Popular Bank and the Bank of Cyprus, is taking the form intended by the banking law. Rather than bailing out the bank (the Cyprus government doesn’t have the money to do so, hence its need to turn to external help –EU/IMF/ECB and to accept the conditions attached), the shareholders, bondholders, and uninsured depositors (in that order) are being bailed in to cover the losses. The insured deposits of the Cyprus Popular Bank, aka Laiki, will be transferred to the Bank of Cyprus along with good assets of equivalent value. Laiki, the “bad bank”, will be put into receivership and its uninsured depositors will receive whatever value can be realized from the sale of its remaining assets (they are expected to lose about 80% of the value of their deposits). The Bank of Cyprus, the “good bank”, will continue to operate but will be recapitalized by wiping out the shareholders, bondholders and about 40% of the value of uninsured deposits. Depositor risk and the market discipline it provides to banks has returned with a vengeance. Hopefully this will be the practice throughout Europe going forward, which could then stop ignoring its no bailout rule.
In a Financial Times interview Jeroen Dijsselbloem, the Dutch finance minister and Eurogroup chairman stated that: “If we want to have a healthy, sound financial sector, the only way is to say, ‘Look, where you take the risks, you must deal with them, and if you can’t deal with them you shouldn’t have taken them on….’ That’s an approach that I think we, now that we are out of the heat of the crisis, should consequently take.”
This is a very promising change in European attitudes. Sadly it shocked so many EU officials that Mr. Dijsselbloem had to back track by saying: “Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday. Macro-economic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.” (quoted in the March 26 WSJ “Shocked about Cyprus”) The big unknown is whether this was too rapid a restoration of market discipline. Changing the rules is always problematic and government explanations to their publics of the situation and their policies for dealing with it have been poor to date. The coming days will be interesting indeed.