“Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it…The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.”
Detlev Schlichter, quoting a 19th Century ruling about the status of bank deposits in the UK. It is, in fact, a sobering thought that many members of the general public might not be fully aware of what actually happens to their deposits, and be aware that to all intents and purposes, they do not “own” their deposits.
Let’s just say that for a lot of people, the Cyprus episode has been a learning experience about the fundamental nature of what banks, today, actually are and do.
If one wants interest from a bank one must allow them to lend out one’s savings.
This means that one NO LONGER HAS THE MONEY (and neither has the bank got it) – the BORROWERS have the money. Till when (and IF) they pay it back (with interest).
If one just wants a bank to look after one’s savings safely (without taking risks with the money) then one should PAY THE BANK for doing so (not expect interest from them).
So far – so pro banker.
However…..
The blance sheet (the books – their whole way of operating) is confusing (deliberatly confusing) for the ordinary person.
For example, people get the impression that their “deposites” are actually in the bank (which is why the word “deposit” is wildly misleading – one LENDS money to a bank, who, in turn, LENDS it to other people and organisations).
And loans are not shown as loans of deposites – they are shown (in a way) as new despoits (money is “credited to the account of” the borrower).
The whole thing is a mess (as described by Murray Rothbard in “The Mystery of Banking” and by de Soto in “Money, Bank Credit And Economic Cycles”).
A totally different system of accounting (of book keeping) is needed – to reflect reality (not fantasy).
“Paul that is an ultra nerdish comment”.
Yes, I admit that, but it is also true.
Otherwise we will continue to have people scratching their heads as a bank collapses and saying “but it had zillions in deposites – its balance sheet is strong…..”
A bank is like a inverted pyramid and the CASH (the only true deposites) is like the capstone the whole inverted pyramid of debt (of smoke and mirrors – of magic fairly dust from the castle floating in the air) is based upon.
Fractional banking, bank book-keeping, how money is made via loans and interest, the Federal Reserve System, and cash deposits on hand rates were all covered in the Intro to Macroeconomics course I took as a freshman lo these many moons ago. None of this stuff is a secret needing some expose’ book to bring the truth to the masses. That the schools aren’t instructing students (and the public as a whole) on how banks operate is not the fault of the bank.
Interesting, I had never actually considered this idea (and I’m sure the vast majority of people haven’t) that money given to the bank ceases to be “our” money and instead becomes the banks money – with only contractual reference to us ourselves. I’ve got to wholeheartedly agree with Paul that a different method of accounting is required. But seeing as banks are run for the good of the banks (or/and government) it seems unlikely to happen.
We the depositors are given a very tenuous grip on that “contract”.
New methods of currency real(i)ty, currency transfer and currency storage are urgently needed. Ones that require minimal third party interaction and zero government interference.
Not sure I follow. Deposits are shown as liabilities of the bank, and loans are shown as assets of the bank. Which is the true position. If deposits remained the property of the depositor, and were merely held for safekeeping by the bank, they wouldn’t appear in the bank’s accounts at all. The problem, surely, is that the average small depositor has no idea about commerce, commercial law or accounting. No conceivable change to accounting procedure can substitute for that basic ignorance. In a world where 50% of the population do not understand that failing to pay off their credit card every month is insanity, nobody can seriously expect ordinary folk to grasp the subtleties of principals, agents, custody and trusts.
Which is why, being more of a conservative than a libertarian, I’m not ferociously against government deposit guarantees. If they were limited to a modest sum like a couple of months wages – say £10,000 top whack – the truly ignorant would be protected, but the bulk of deposits would represent liabilities to the slightly more sophisticated. (I’d make it so the banks had to pay for the guarantees, and so banks weren’t forced to have guaranteed deposits so long as they had an enormous cigarette style health warnings saying so.)
I’m all for stuff like the FDIC simply because otherwise you end up with repeats of the Panic of 1907 and the Great Depression. If nobody has any faith in a bank being able to return a deposit, nobody will deposit money, so no loans, no economic improvement, and so on and so forth. I don’t know how things work across the Pond, but the FDIC is nominally run by the government, but receives no funding from the government. Banks pay a premium just like any other insurance and other funding come from interest from Treasury Bonds and as a last resort the FDIC can borrow from the Treasury to cover deposits, but sold assets and the Fed will be forced to pay that back.
“I don’t know how things work across the Pond, but the FDIC is nominally run by the government, but receives no funding from the government. Banks pay a premium just like any other insurance and other funding come from interest from Treasury Bonds and as a last resort the FDIC can borrow from the Treasury to cover deposits, but sold assets and the Fed will be forced to pay that back.”
I don’t claim to be an expert, but I thought that in the end the feds are on the line – ie if the FDIC runs out of money, it can get the money to pay depositors from either the Fed or the Treasury. Maybe that’s what you meant by “but sold assets and the Fed will be forced to pay that back” ? Anyway if they ain’t got anything left, they can’t pay it back.
Let’s say I own a bank and you and you buddy Joe both deposit $10,000. I have a Reserve Rate, which is how much cash I’m required to have on hand, of 10%. It’s figured out from an arcade formula based on how much I have deposited, how much in outstanding loans, how much in collateral, default rate on those loans, etc. I have an operating expense of $1,000. Part of my normal operating expenses is a check I cut to the FDIC that is effectively an insurance payment. So I have the $17,000 to loan to the Acme Widget Company. The Acme Widget Company borrows $20,000 from me. But I only have $17,000 to loan you say. True, but I borrow $3,000 from Bob’s bank down the road.
The Acme Widget Company goes tits up one morning. When they file for bankruptcy my bank will get some of the money back, but that takes a while. In the meantime Joe comes in to withdraw his $10,000 to go on a hookers and blow binge. I only have $2,000 in cash, right? So I have to borrow the rest from the Federal Reserve to cover his withdrawal plus the new Reserve Rate cash. My bank is in pretty bad shape, but it gets worse because Bob’s Bank calls in the loan they made to me.
The first thing I’ll do is call the Federal Reserve to try to get another loan. They’ll say no and I’ll file for bankruptcy. Before any of my creditors get paid, the FDIC will pay off the depositors. Let’s say it’s been a bad week for banks everywhere and there isn’t enough money in the FDIC coffers to cover my bank, Bill’s Bank, Tom’s Bank, and Harry’s bank. The first thing the FDIC will do is contact the Federal Reserve for a loan. Let’s say the FDIC can only borrow from the Federal Reserve just enough to pay off my bank and Bill’s bank deposits. So the FDIC will get a loan from the Treasury Department to cover the rest of the deposits. The depositors have lost no money at all, but the FDIC now owes both the Federal Reserve and the Treasury Department.
When my assets (other outstanding loans still being paid on, collateral, physical properties, stocks and bonds, etc.) are sold off to cover my bankruptcy, the FDIC gets first crack at those assets. They’ll immediately pay back the Treasury Department and the Federal Reserve first. They’ll also raise the rates of other bank’s premiums and adjust those banks Reserve Rates so that at risk banks have to have more cash on hand. It’s a gross simplification of the process, but in the end the FDIC will end up paying back both the Federal Reserve and the Treasury Department. Obviously that becomes easier when the Fed can just turn on the printing press but in theory the taxpayers never risk anything. If my assets are not enough to cover the amount the FDIC borrowed, then the FDIC eats the cost and just raises everyone else’s premiums to cover their loss. The FDIC is kind of like the Post Office and Public Broadcasting in that they are both owned by and run by the government but receive no funding from the government. Any money that goes to cover the FDIC must be repaid before anyone else according to the law.
To say “you don’t own the money, you only have a contractual guarantee of payment of the money on demand” seems like a distinction without a difference.
Paper currency originated as a guaranteed payment of silver or gold coin (“real” money).
Yet it soon became accepted as a medium of exchange – which is the function of money.
The value of a guarantee of payment is generally the amount of the payment, less some discount for the risk of default. The guarantee practically amounts to current ownership.
I would further add that a loan of a physical article is understood not to convey ownership. If Bob lends Joe his hammer, it’s still Bob’s property. Money is not physical, but I don’t see that that makes a fundamental difference.
I have been reading the comments sections of various newspapers and blogs this last week in ever increasing exasperation. Thank Christ someone (the always insightful Detlev Schlichter) gets it. This has been a long overdue learning experience for depositors worldwide. Your deposits are a LOAN to the bank and if it mismanages that loan, you stand to lose some or all of it. If you don’t like that deal, put the money under your mattress or invest it somewhere else. The problem is that if enough people suddenly decide to do so we will see the final collapse of the entire western banking system.
My modest proposal is a single National Bank that IS backed by government deposit insurance, but is constrained by ultra-high capital adequacy ratios, ultra conservative lending criteria and an absolute bar on stock market or derivative trading. Most western governments have a choice of banks they already effectively own that could be converted to serve that purpose.
I agree 99% with Lee’s comment of 7:53 PM. The only point of difference is that he says he doesn’t object to government deposit guarantees. The guarantee doesn’t bother me; it’s the “government” part that does.
The government is not competent to guarantee deposits: it necessarily follows a “one-size-fits-all” scheme which doesn’t properly price for risk or reasonably ensure that banks aren’t taking undue risks. (I won’t go into detail here on that latter point, but all you have to do is think about how banks loaded up on credit default swaps and Greek debt without a peep from the regulators to see what I mean.) The solution is private deposit insurance.
Private insurers would have their own capital at risk, so they would have every incentive to institute a rational regulatory scheme for the banks they insure, as well as to have differential pricing to reflect different degrees of risk (just as with life insurance). Banks could shop among insurers to get the best terms (regulatory burden and price), as well as to select the level of deposits they wish to ensure. Customers could choose banks based on the amount of deposit insurance they want (knowing that a higher level would mean it costs more, so their interest rate would be somewhat lower); they could even choose an uninsured bank provided that the interest paid was high enough to compensate for the increased risk. And the government would be out of the deposit guarantee business, so there would be no risk to the Treasury.
When my place of employment was a bank, deposits were debts and loans assets.
1. Steven – thanks for the explanation. I still feel slightly like I’m watching three cups being moved round though. If your assets are insufficient to repay the FDIC, the FDIC still owes money to the Treasury and the Federal Reserve. If the FDIC’s reserves are exhausted, then it needs to get the money from other banks. Which is fine if the other banks have enough money. But if the other banks run out of money too, then the FDIC is still bust and can’t repay the Treasury and the Federal Reserve. So the FDIC’s going to be fine if it’s just a few small banks that go under. But in a major bust the FDIC will be in trouble, and if it starts making giant demands on the “solvent” banks, they’ll go bust too. So the “no risk to the Treasury or Federal Reserve” seems to boil down to “no risk…so long as it’s not too bad.” Maybe that’s how 2008 would have turned out if the Fed hadn’t turned on the fire hose. But anything like Greece or Cyprus would bust the FDIC. In fact, if the FDIC can make unlimited demands on the solvent banks that seems to me to make it worse, as it’ll guarantee that even the good banks will go bust however prudent they’ve been.
2. Laird – I’m in favor of private insurance too, but insurers can go bust too. (As AIG did.) A simple way of doing a government guarantee is just to insist that all deposits below £10,000 are 100% backed by government securities, held in an escrow account.) The government doesn’t have to guarantee anything then. The banks only then get to do their fractional reserve thing with unguaranteed deposits. (Obviously this still wouldn’t work in the Eurozone, but it would be fine in countries which have retained their own printing press.)
Since when is it a conservative position to encourage moral hazard?
Beacuse that is exactly what government deposit guarantees do… they privatise profits (i.e if the bank makes money with the money you have loaned them) whilst collectivising losses (causing the uninvolved who do will never benefit any profit made from the risk to bail out the people who *did* take the risk if it all goes wrong). How can this *not* lead to perverse incentives?
Look at it this way… imagine you borrow money from a bank. Is that your money now? Yes it is. You can choose how you spend it and how you manage your agreed repayment because it is indeed your money now. What the bank has is a promise from you to repay it under whatever conditions were agreed but the bank no longer has that money… you do.
And when you put your money in a bank, you are lending that money to that bank, and the bank repays you via interest. They also agree to give it back if you ask for it (depending on the type of account, there may be restrictions on how much and when, because it is in fact a loan from you to the bank). But until you do ask for it back, in part or in full, it is the bank’s money to do with as they please. It is their money.
The only time this is *not* the case is if the bank offers a ‘safe keeping’ account. These are not loans but rather either figuratively (or sometimes literally) simply safety deposit boxes for your money. The bank cannot ‘do stuff’ with your money, because it does not own it… you still do… it only looks after it. It is like keeping a life insurance document in a bank safe deposit box. The bank does not own your policy and cannot trade on it, it just looks after the box it sits in. And thus not only does the bank not pay you interest on a ‘safe keeping’ (because they are not loaning it out and making interest themselves) they will actually charge *you* a service fee to look after your money.
But if your money is making interest, actually it ain’t really “your” money, it is just a repayment for your loan to the bank.
That is most certainly not a “distinction without a difference”.
The banks also collectivize profits in the form of interest rates and dividends for depositors. Plus banks don’t exist in a vacuum. If My neighbor loses everything when his bank folds, I’ll be right out front of my bank when it opens, and so will a bunch of other folks. Then we have a bank run and the rapid collapse of the banking system, which was seen in 1907, 1919, and 1929. Maybe it would have been better for the banks to have set up a private insurance scheme to prevent the depositors from losing their shirts if/when the banks failed, but they simply had no interest in doing so. It shouldn’t come as a great shock that people asked government to force that creation when the private market dragged its feet.
It’s a question of the lesser of two evils. If you want a banking system, you have to have confidence in the banks and if people feel their money is more secure in a pickle jar in the back yard than it is in a bank, you have no banking system.
Perry de H : “Since when is it a conservative position to encourage moral hazard?”
A very wicked thing, of course. However I don’t think my 100% fraction plan for deposits under £10,000 creates any moral hazard, because the banks don’t get to play with that money. Small depositors can bank “risk-free” using the bank just as an efficient payment system, while larger depositors get to take the risks. Obviously the banks won’t pay the small depositors much interest – ie government debt yield less expenses, which may work out to be negative overall – but they can always keep the money under the mattress instead if they prefer.
For myself the convenience of electronic payments leads me to keep small amount in the banks even though I know there’s a risk. And I’d still keep some in the bank even if I was being paid minus 1% interest.
A great many people with Cypriot accounts would indeed have been better off with their money in a pickle jar. That is the whole problem with telling people it does not matter how awful their bank is because the state will make sure nothing bad happens to them. What possible care would they have how secure their bank is as a result? And indeed what possible care does the bank have to be prudent as they know, and the people they do business with know, that much of their assets are in reality not commercial risk at all but actually sovereign risk?
When you divorce reward from risk, this starts a train of consequences and eventually the system gets more and more ‘weird’ as perverse incentives move people further and further from reality.
It is not ‘if you want a banking system’, it is ‘what kind of banking system do you want?’… or more to the point, what kind of banking system do you really need?
If you want a banking system where risk and reward can be meaningfully correlated, banks need to be allowed to go bust with all that implies. That does not undermine the system, it is a core function of any long term viable system.
Apples and oranges. The banks in Cyprus aren’t screwing around with savings deposits; the Cypriot government is. And when the banks are permitted to open the result will be the same: bank runs as we saw in 1907, 1919, and 1929. There will be zero confidence in the banking system. Look at it a year from now and tell me how their banking sector is doing once nobody keeps money in a Cypriot (and probably PIIGS banks).
As far as the “best of luck” banking system we had, there’s a reason it’s in the past tense: for depositors (not investors) it simply did not work and the market had no inclination to do anything to change it. Everyone on Wall Street said the same thing “trust in the banks, put your money in a bank instead of a mattress, it’ll be safe with us and we’ll put it to work” and time and again the bank would go bust and Ma and Pa Kettle would lose everything. So the choice was A: make sure Ma and Pa Kettle were protected or B: not have a banking sector. You can’t have a banking system that works if nobody trust banks enough to put a deposit into it. It might look great on paper to do otherwise but history proves it simply does not work.
Perry, I agree about the moral hazard issue, but I still think that having insurance on small deposits makes sense. As a practical matter it’s unreasonable to expect people with only a little money to be sophisticated enough to understand bank balance sheets. But our insured deposit limits are far too high today, so the moral hazard is real. (In the US it’s $250,000 for interest-bearing accounts and, as far as I can determine at the moment, essentially unlimited for demand accounts. Not many banks that fail are actually liquidated, so the insurance limits aren’t often tested and for the last several years Congress has mandated that most amounts be covered.) But I still think the insurance should be private, not government-run, for the reasons I explained earlier.
Lee, your idea of backing small deposits with government securities isn’t terrible, but it’s not good enough. First of all, you’ve essentially created a money-market account, so the only interest the bank could pay would be the current Treasury rate minus overhead and a profit margin. Today, that’s probably a negative number. Second, government securities themselves aren’t without risk; witness Greece, etc. The US is heading down that same path.
You’re certainly correct that insurers can go bust, too. The bank can help guard against that by being careful of the insurance carrier it chooses, and its depositors should employ the same diligence because ultimately their claims would be against that company. Banks would advertise the quality of their carrier as a marketing tool. But in the end you cannot guarantee against all risk. People need to be reminded of that unpleasant fact.
Jesus de Soto is the man for this. The rule should be: 1. If it’s a sight-deposit, then the bank is acting purely as a trustee, and the money is yours. Any use of it is therefore breaking the rules. However, be prepared to pay the bank for the service of keeping that deposit in custody. 2. If it’s a time deposit, then you’ve just made a loan to the bank (on what is probably very bad terms): and good luck to you.
You cannot “put your money under the mattress”, as you can’t do anything without a bank account. It is pretty much impossible to get a job without a bank account. The best approach is to go with a cooperative or use only a debit account (credit cards are for the feckless and gullible), rejecting any of the dodgy “offers” (all cons) which the bank tries to seduce you with.
I agree with Paul.
The current system is a con. It reminds me of your average friendly-adviser-costa-del-sol conmen that I got to know so well.
Average Joe Bloggs, salt of the earth, good guy, whatever, doesn’t stand a chance.
It’s just clever city slickers fleecing the mugs.
Poor mugs.
Or do we also despise them?
What I’ve always found difficult about these deposit insurance schemes is that they insure the bank rather than the client. As in x bank runs out of liquidity and so cannot pay out its accounts so the government pays the bank rather than sending a cheque to the depositor, who can cash it bank it where ever.
No, that is not ‘collectivize profits’… it is private profits for the bank’s customers. I am talking about collectivised losses in the sense that the losses are taxpayers pick up the losses from bad risk taking whereas the successful risks are enjoyed privately (i.e. the bank and its customers, not the taxpayer).
Simply not true. For most of the history of banking, deposits have not been guaranteed and yet banks still existed. Banks go bust, runs on banks happen and confidence waxes and wanes in accordance with reality. Banks need to be allowed to go bust or all that happens is problem get shifted around and stored up for the future (i.e. the place we are rapidly arriving at right now).
Yeah but for most of the history of banking, most people had no dealings with banks. Their clientele was restricted to the relatively rich and sophisticated. Your average peasant dealt in cash, paid in cash and hoarded in cash. What’s different these days is that most people have bank accounts, and banks are very efficient payment systems. Preventing the peasants from using banks, and making them go back to cash, simply because they don’t want their wages paid into a bank for fear of a bank run, seems a triumph for ideological purity over practicality.
Au contraire. Treating the peasants as peasants unable to make decisions about risk is a triumph of statist ideology. The reality is that the moral hazard of removing consequence from risk leads inevitably to systemic problems of the sort that (for example) caused the sub-prime fiasco.
And in any case, I think ‘my side’ has actually won the debate in the corridors of power… my prediction? As it is politically impossible to take away people’s free stuff gained at other people’s expense, deposit insurance will remains but 20 years from now, it will still be limited to €100 k, which (assuming the Euro even still exists in 20 years) will buy the average person a nice dinner for two at a five star restaurant 😀
Stuart, that’s simply incorrect (in the US, at least). When a bank fails, the usual scenario is that the FDIC brokers a sale of its deposits (and generally at least some of its assets) to another bank, which then continues to honor all deposits; they are fully accessible via ATM or check, just as before. The only change a customer notices is a new name over the door. Bank liquidations are relatively rare (only 25 in the last 10 years, despite hundreds of bank failures) but in such a case, where the FDIC cannot find another bank willing to take over the deposits on acceptable terms, they simply mail a check for the insured amount directly to depositors. It is the depositors who are insured, not the bank.
You can’t see deposit insurance in the same way you see other insurance, because the exposure is fundamentally different.
If you have a car wreck, that doesn’t provide any incentive for anyone else to go out and have a car wreck of their own. Car insurance can be based on actuarial statistics.
Deposit insurance, on the other hand, is insuring public confidence – it’s the only form of insurance that creates its own claims. If you pay out on one failed bank, it actually encourages people to do things that will make more banks fail. Look, they paid out when the First National Bank of Larnaca went TU – let’s go get our money out of the Second National, while we still can . . . . .
The only form of deposit insurance that would make any sense is one which has assets equal to 100% of the assets insured – which makes no sense at all. Deposit risks are irrational, not subject to the normal laws of chance and large numbers. And I, personally, don’t think that you can create any sort of insurance against irrational, unquantifiable risk – and a hundred times more so for any state attempt to create such insurance, which will be immediately corrupted by all sorts of political and venal incentives.
As we see in Cyprus, where the plan now is to steal the money only from the very rich, complete with vague assertions that they’re all Russian mafiosi anyway, so who cares? If you step back and consider, you actually have to admire their brass neck – they’re fixin’ to fund the bailout they caused with money that they freely assert was stolen from somebody else. As if stolen money is somehow ‘found money’ – free for anybody to use if they can just lay hands on it. The idea that this money, that they say they can take because they say it’s stolen, might actually be returned to the people it was stolen form, doesn’t even seem to enter anybody’s heads.
llater,
llamas
I disagree, llamas. First, if one bank failed and the insurer paid off the depositors, it would inspire confidence in that insurer and would make it less likely, not more, that people would withdraw their funds from other banks insured by that same company.
Second, while you are correct to a certain extent that deposit risk is not subject to the normal laws of chance and large numbers, that doesn’t mean it’s not quantifiable or, more importantly, subject to control. It has happened before: one of the earliest forms of insurance was fire insurance, and the insurance companies set up fire companies for their own benefit. A similar thing would happen with private deposit insurance. Any insurance company writing deposit insurance would establish for ite client banks capital limits, lending guidelines, and asset valuation methodologies to ensure that the risk is limited and understood. It would regularly audit the bank to be confident in the accuracy of the bank’s accounting and in the quality of its assets. Any bank which failed to meet its standards would risk losing the insurance, which would be disastrous for the bank. The point is, an insurer with its own capital at risk would provide far better oversight and control than a governmental entity ever could.
“If Bob lends Joe his hammer, it’s still Bob’s property. Money is not physical, but I don’t see that that makes a fundamental difference.”
This quote from Rich Rostrom’s comment can be used to explain the situation to those who insist that money has been “seized” from depositors’ accounts.
If Bob lends Joe his hammer, and Joe breaks it, then Bob is no longer the owner of the hammer, because there is no hammer to be owned. Bob has a claim to be compensated by Joe, but if Joe is broke, then this claim is worth nothing.
Substitute:
Bob –> a depositor
Joe –> a “bad” Cypriot bank
hammer –> money
breaks it –> lends it to the Greek government
and you’ll understand the situation without having to read Schlichter or Rothbard or Mises.
To continue the analogy:
If Joe is a minor, Bob can claim money from Joe’s parents, but if Joe’s parents are also broke then Bob ain’t gonna get any money.
Substitute:
Joe is a minor –> the deposit is insured
Joe’s parents –> the Cypriot government
WRT lending hammers, note also the Life of Brian reference.
llamas @ 3.27pm
Stealing money from the Russian mafia strikes me as not without its own hazards.
“If Bob lends Joe his hammer, it’s still Bob’s property. Money is not physical, but I don’t see that that makes a fundamental difference.”
I think it does make a difference. Money is disposable in ways a hammer is not. You borrow money, you own that money to invest or dispose of as you will. With a hammer, the hammer cannot be melted down to make something else and still be meaningfully returned to the lender. I accept that…own… control… lend… all do have shades of meaning but I think the person who has the loan really does ‘own’ the money and all the lender owns is a (tradable) promise to repay it.
Laird – then we’ll have to disagree some more.
Firstly, I agree that paying off the depsitors of a failed bank increases the confidence in the insurer – but it’s not the lack of confidence in the insurer that creates the problem, it’s the lack of confidence in the bank(s) – about which, the insurer can do nothing.
Secondly, I disagree that a deposit insurer can effectively limit his risk by (all the measures you stated). When customers lose confidence in a single bank, they often sequentially lose confidence in all the banks – not just the poorly run ones – and a bank run, once it starts, can swallow many banks in succession. The only thing you can say, in the long run, is that the better-run banks might take longer to fail – but fail they will.
Bank runs have a positive feedback loop that is impossible to quantify, because it depends on non-quantifiable subjective concerns like fear, confidence and optimism.
There’s also the secondary effect (that we see in Cyprus) where the state effectively renegotiates the deposit insurance contract – your money is safe from a bank run, but not from state-sanctioned confiscation. To the depositor, the end result is the same – somebody took my money – and this sort of thing encourages bank runs, no matter how prudent the insurer or how carefully-run the bank.
llater,
llamas
llamas, as to your last point, that merely supports my contention that the problem isn’t deposit insurance per se, but government deposit insurance.
As to the rest of your comment, I disagree with it all. In my scenario, confidence in the insurer is entirely the reason for confidence in the bank. As to bank run “contagion”, that did sometimes happen in the past, but that was before deposit insurance. It doesn’t happen now (witness the hundreds of bank failures since 2006, with no “systemic” runs), and it would be just as unlikely to occur with a recognized and respected insurer standing behind the bank.
Perry de H : “I think it does make a difference. Money is disposable in ways a hammer is not. You borrow money, you own that money to invest or dispose of as you will. With a hammer, the hammer cannot be melted down to make something else and still be meaningfully returned to the lender.”
There’s a difference but that’s not it. The difference is that when you lend someone a hammer, the understanding between you is that you will get the same hammer back. The hammer that is the subject of the loan is not intended to pass permanently out of the ownership of the lender. Whereas with a loan of money, the understanding is not that you will get the same notes and coin back. It is understood that the particular notes and coins that you hand over pass permanently from your ownership, and what you will get back is different note and coin of the same value. The difference lies in the understanding – or contract if you prefer – not in the type of thing lent.
It would be perfectly possible to agree to lend money in the hammer sense, ie where the borrower took the money into safekeeping and handed back the same notes and coin, but that’s not what banks do, and notwithstanding some suggestions to the contrary, their customers do not expect them to do it.
One of the good things about the Channel Islands (Guernsey and Jersey) was that there was no “Deposit Insurance”. No moral hazard, no giving people who put money into banks false confidence (and the feeling they did not need to carefully check out the bank – and watch its activties each day DEMANDING that is books obey the laws of reason, rather than the customs of credit bubbles), and no blank cheque committment for the taxpaypers.
Yet how did the rulers of these places react to the events of 2008 onwards (which prove, yet again, what a crippling burden on taxpayers standing behind the banks is).
The rulers reacted to these events by ADOPTING Deposit Insurance (setting up their own schemes).
It is difficult not to despair.
What Mr. Marks said at the top: If one wants interest from a bank one must allow them to lend out one’s savings. – where do people think the Bank makes any money?
If the money was “Seriously Yours” such that they couldn’t loan against it, not only would you not be earning interest on it (for risk or time preference or both), you’d be paying (significant) fees to operate the bank for the convenience of letting it hold your money securely and disburse it for you.
(Which, hey, some people might prefer, so I think it’s a fine option if someone wants to make such a thing happen…)
I don’t see a particular problem with the quote making up this post; you loan the bank your money. They pay you interest on it and have a legally binding commitment to return the money on demand (or with other terms, depending on the specifics, like a CD). If they won’t or can’t, you have a claim against the remnants of the bank (remnants because banks naturally only won’t pay out “your” money when they collapse).
(You’re acting as a creditor to the bank, essentially. The rest of the analysis is out of any standard analysis of Credit. See, say, Rothbard or Mises.)
“When they sacked Rome, the money was already long gone.”
All in all, it’s a pretty funny loan when the borrower (the bank) rather than the lender (the depositor) gets to vary the interest rate.
Perry de H: Bank deposits and bank loans are on substantially different terms.
The rule on deposits is that the money is available on demand. With a Certificate of Deposit, the depositor can still get the money on demand, but forfeits interest.
With loans, the lender has much less immediate power to call in the money. With mortgage loans I don’t think there’s any such power at all.
The converse of a mortgage loan is a bond – where the buyer agrees that the principal cannot be had back on demand.
However, it is an interesting philosophical question. As you note, Joe’s $100 in my wallet feels a lot more like mine than Joe’s hammer in my hand.
Also note that there is no such thing as “title” to money.
Actually, AndrewWS, I’m not aware that happens. They can’t change the rate on a CD except when it matures (i.e., when it becomes a new “loan” with different terms which you can accept or reject), and if they change the rate on your savings account you can always “call the loan” and pull your money out, thus rejecting their new offer. So in what circumstance do you think a bank can unilaterally change the interest rate while forcing you to leave the money there?
I don’t think it would work that way in practice. Confidence in the insurer would be likely drop for two main reasons:
1. The insurer’s willingness to insure a bank which failed would make people question its judgement.
2. The act of paying out would reduce the insurer’s ability to pay out for future failures.
Funny how it doesn’t work that way with any other type of insurance, Paul. Why do you think this would be different?
It does work that way.
Nonsense. If an insurance company promptly pays massive claims for, say, hurricane damage over a wide region, people will become less confident in its claims-paying ability in the future? If my automobile insurer treats me fairly when I have a claim I lose confidence in its ability to do so in the future? What universe do you inhabit?
Anyway, so you’re arguing for government deposit insurance? Really? Because they’re so reliable and everyone has ultimate confidence in them?
Yes, because if insurance companies insure major risks and pay out huge amounts on them, they have less ability to pay out future claims.
Probably not, because you are one isolated claim. Deposit insurance doesn’t pay out on single accounts, it insures events which impact all accounts with an institution simultaneously.
One where logic and reason apply.
No, I’m not and if you look at what I’ve posted, you’ll see that nowhere have I argued for government deposit insurance. All I’m arguing is that private deposit insurance is pretty much pointless.
“Yes, because if insurance companies insure major risks and pay out huge amounts on them, they have less ability to pay out future claims.”
Fine, give me one example of an insurance company which lost customers after paying out major claims. I don’t think you’ll find one. You are obviously correct that major claims deplete the company’s reserves, but that’s why they have reserves in the first place. Furthermore, most people don’t think that way. You’re merely speculating on no basis. And in my proposed system, if you think deposit insurance is pointless you’d choose to go with an uninsured bank and take the higher yield. Your choice, but I doubt that many would be joining you.
I would expect a lot of people to go down the uninsured route, as there would be no point taking a lower yield for no discernable reduction in risk. In the real world, people reduce their risk by spreading their deposits around, more than by seeking out what is perceived to be the absolute safest haven for them.
Your proposed system is based on contradictory premises. You said:
Which is a reasonable point, but you also said:
Which is expecting people with only a little money to be sophisticated enough to understand insurance company balance sheets, their access to liquidity and their actuarial work. Your idea might add value if insurance companies were 100% safe and reliable, but in reality, they are inherently no more secure than banks.
My previous post saw a role for the state in providing a backstop to guarantee deposits. I am not so attached to that position that I cannot see the value of alternative models. I’ve seen someone here advocate for a private insurance company to provide deposit insurance. I can see the risk in that with the proven hubris of AIG, but I can also see the potential. We have seen how Kyle Bass shorted the market in order to win big from the collapse of the market with puts on the CDS market.
Here’s the thing, if you take put options on any given bank at a little above zilch, it will pay out massively if the bank goes tits up. Now, you have to do this every month, but it costs pennies to do it. If you are doing this regularly, then that ongoing cost can be tallied up each year and become an annual cost, which would be made into a premium. I am sure that there are quants out there that could come up with a formula that could work out a monthly payment that would completely cover the loss from a single bank’s bankruptcy.
The takeaway is this: – have some company take a monthly fee in order to buy put options on the demise of any given bank that will pay out massively if that bank fails. Because this is so cheap, it can be charged to the customers as a deposit insurance that will pay out if the bank goes bust. Transparency is the key. Let anyone look up all the figures online in order to nitpick, criticise and make an informed decision. And if you can’t be bothered to do that, you deserve whatever comes to you.
As always, the answer is complete transparency, with each company involved in this market posting their strategy and accounts online for all to examine and criticise.
“if you take put options on any given bank at a little above zilch, it will pay out massively if the bank goes tits up”
…….always assuming your counterparty hasn’t also gone tits up.
Neither a lender nor a borrower be, but if you must, be a borrower. Cos then you don’t have to worry about counterparty risk. Besides which you’ll be on the same side of the trade as the government, which helps limit the retrospective legislation and the “hey guys, let’s just print some more” risks.
I like Lee’s points!
Paul, I think I’ve made my point and I disagree with yours, so we’ll just have to agree to disagree on this. 🙂
I like the way DeotT thinks. The difference is that Lee and Laird and some others are looking at how our system really works and working within that system, and DeotT is proposing how it should work in a free market. Transparency is the key element. As soon as depositors have skin in the game, ratings services will pop up like mushrooms dissecting the solvency of various banks and insurers. The premiums will quickly reflect the markets assessment of risk which even with ignorant/passive depositors will still show up as either higher fees and lower returns or disclosed lack of deposit insurance.
I will happily take the ongoing vibrations and wobbles of a free market over the ballistic trajectory of a controlled market.
Hmm. Just a few musings.
How consistent is transparency with a free market, I wonder ? Businesses generally like to keep their affairs secret, for good profit maximising reasons. The theory seems to be that depositors will refuse to deposit any money in any bank that chooses not to be perfectly transparent. This seems unlikely to me. After all, lots of depositors who have deposits above the insured limits seem happy to bank with banks as they are now.
Secondly, how trustworthy would free market ratings agencies be ? Let’s leave aside the sheer magnitude of the task and focus on the market incentives for ratings agencies to be accurate and truthful. In social endeavors there is a cost to being diligent and honest, and a benefit to being perceived to be diligent and honest. The way the market usually tries to marry these competing interests is in the value of long term reputation. But if modern business has taught us anything it is that it is very difficult to get employees, senior or junior, to care as much about the long term reputation of their employer as they care about their own wallets. The traditional trajectory of a long term city professional is to build up a reputation over thirty years and then milk it for the last ten or so.
There are of course men and women of integrity and diligence who are motivated by more than their wallets – who will refuse to “defect” in game theory terms, once they have a reputation, simply because it would be wrong or what used to be called “unprofessional” to do so. But – he muses – perhaps there are rather fewer than there used to be. And perhaps the problem is indeed transparency. Perhaps in the days when a slightly greater proportion of commercial people in general, and commercial professionals in particular, believed that their every action, indeed their every thought, was visible to someone who would weigh their lives in the balance at a future date of reckoning, the risk of defection was lower.
Midwesterner:
If it were to work that way, we would have another reason why private deposit insurance would be pointless. In order for deposit insurance of any kind to be useful, I have to have confidence that it will be in place for as long as I may have a deposit. If I place a deposit on day one and the insurance company refuse to offer cover on day 2, then on day 3, there’s a risk of a bank run where I may not get my money back.
Withholding information from your insurance underwriter could and should leave you open to strict liability. Holding bankers strictly liable has worked well in the past.
Contingent capital and risk taking: Evidence from Britain’ banks 1878-1912
That is for the futures options market and other forms of underwriters to decide.
Where I live, insurance companies are required to give advance notice of cancellation. Even if I miss a premium, they still cover a grace period. If bankers violate the terms of their insurance contracts, see ‘strict liability’ above.
Would strict liability reduce the scope and flexibility of financial instruments available? Hell yes! Would that be a bad thing? Conservative banking used to be considered not just a good way to run a bank, but the only way to run a bank.
Paul, now I think you’re being argumentative merely for the sake of being argumentative. In the real world ratings don’t evaporate overnight. If a bank’s financial condition begins to deteriorate a ratings downgrade warning would first be issued, then then the downgrade(s) would occur in steps over time. All along the way the ratings would be public (and certainly known to the insurer), the insurance premiums would increase, and possibly the amount covered (the insured deposit limit) would be reduced. Undoubtedly through all this the insurance company would be insisting that the bank improve its capital position or risk losing the insurance altogether.
All of this happens in increments. You would have plenty of time to withdraw your funds should you become concerned (which would also put pressure on the bank to mend its ways). The point of all this is that market forces, rather than government mandates, would provide every incentive for banks to be careful and prudent in their lending and investing practices. Which is precisely what the current system of governmental insurance and regulation does not do; in fact, every incentive today is precisely in the opposite direction. That’s the moral hazard of a government insurance system.
Midwesterner:
Think that through. If an insurance company were to give advance notice of cancellation and that were to be made public, there would be a rush to extract deposits prior to the insurance disappearing, forcing the insurance company to deal with exactly the type of event it is trying to avoid.
The whole thing would be a house of cards, because the insurance company would be directly influencing the event it is insuring against.
Laird, I thought we were “agreeing to disagree.”
I’ve no desire to interact with you if you are going to put your own point across and then passive agressively attempt to silence me when I respond.
Well, duh. See Laird’s comment above. There is a reason it is called “insurance” not “taking money and offering nothing in return”. Assessing risk and covering losses is what they are paid for. I’m inclined to agree with Laird that you are arguing just avoid acknowledging things you don’t like. Insurance and reinsurance are long established and highly developed institutions. What is wrong with our present state is putting tax-payers and Federal Reserve Note holders assets up to cover risks undertaken by business who keep the profits when their gambles pay off. Put the risk-takers skin back in the game and the game will change.
I get a lot of argument, even here on Samizdata, but limited liability is the most severe moral hazard of our time. If you cannot get free market liability insurance for whatever risky activity you want to undertake, not just banking – any risk to others, you should not be doing whatever it is you cannot get liability insurance for.
This means that when people sign contracts that include a waiver of liability, the laws have to recognize it and the courts have to enforce it.
Paul, you were making a different point. I never promised to remain silent on that.
Midwesterner:
Which is true, but also doesn’t contradict anything I’ve said, as you seem to be implying. Also, what you need to allow for, is that in the case of deposit insurance, what is being insured in the first instance is generally not losses, but access to liquidity, which is a very different proposition.
So is banking, but it still falls foul of liquidity problems. As good as insurance companies are, I don’t share your belief that they can magically remove the liquidity risks which are inherent in a fractional reserve system.
I agree. It is a dangerous, moral hazard inducing state of affairs. However, it isn’t quite as ridiculous as what you and Laird are trying to sell, as it does at least have a meaningful impact. It is supposed to give depositors confidence that in a crisis, liquidity will be available to pay them out, which is something that only the state can ultimately guarantee, as it is the organisation which creates fiat currency.
Insurance companies aren’t in any stronger position to guarantee deposits than a bank – in many ways, they would be worse off, so transfering risk to them would achieve little. I don’t particularly have a problem with the concept of private deposit insurance, I just think it needs to be viewed in a sensible way, which means not viewing insurance companies as mystical organisations which can be absolutely relied upon to have continuing access to huge amounts of liquidity even when banks don’t and are failing.
What you’re proposing, with private deposit insurance, is exactly the opposite. The whole purpose of insurance is to enable the risk taker to take some skin out of the game. It’s the same effect we’ve seen with CDOs.
Laird, on that basis:
In your example, you have two external actors – the rating agency and the insurer.
The rating agency operation as presented I have no problem with. Assuming the agency has access to sufficient information, isn’t corrupt and doesn’t face perverse incentive, it would be providing a useful supply of information.
The insurance company, however, is a different matter. You present it as something which can be relied upon without question, even though it is operating in exactly the same marketplace as the bank. If as a depositor, I need ratings decisions and insurance in order to feel confidence in dealing with the bank, then if the risk is transfered to the insurance company, I will want the same of them, which makes the whole thing circular.
Paul, you are a waste of time. Not for the first time, either. If somebody wants to deposit their money in a fractionally reserved bank, it is their decision. Not yours. You are picking, choosing and setting up straw men in order to make your case, which appears to be the complete prohibition of consensual fractional reserve banking. The only proper function of government is to protect people from force, not from consensual relationships. You would forcibly prevent them the option of choosing a FRB bank. Free banking (which requires an end to legal tender laws) is all that is necessary for a sound and stable system of trade.
Midwesterner:
Pot. Kettle.
I agree.
No it isn’t. I have no desire to prohibit consensual fractional reserve banking.
I agree.
No I wouldn’t.
You’ve just posted possibly the most embarrassing screed I’ve ever seen. You accuse me of setting up straw men, then done nothing but set up straw men, attempting to ascribe to me positions that I do not hold. How sad.
Quoting:
at March 29, 2013 at 7:22 pm
at March 30, 2013 at 6:52 pm
at March 30, 2013 at 9:08 pm
A reasonable person would conclude that either you want to prohibit FRB, which you deny, or that you wish to require government deposit insurance, which you also deny but simultaneously stipulate that it is the only workable solution. The only third option I can see is that you want to prohibit private deposit insurance. You haven’t denied that yet.
I said that only the state can ultimately guarantee to make liquidity available, but that is clearly not the same as saying that the state should guarantee to make liquidity available.
I did say this:
I think I’ve been quite clear in what I’ve been saying:
– I don’t support the general concept of state deposit insurance, as it passes the risk from those involved in investments to those not involved.
– I don’t want to prohibit FRB.
– I don’t want to prohibit private deposit insurance, but it is pretty much pointless and certainly cannot replicate what state deposit insurance achieves.
So, in other words, you would leave the present system just as it is, you just don’t “support” it.
Got it.
Midwesterner, I’m loathe to indulge what is now obviously just trolling, and poor quality trolling at that, but to clarify what is already perfectly clear – I do not support the concept of state deposit insurance; I am not in a position to change the system, but if I were, I would phase out state deposit insurance.
OK, Paul, now I’m confused, too. If I understand you correctly, you don’t want to prohibit consensual FRB; you don’t like governmental deposit insurance (although you seem to be tepidly in favor of the government guaranteeing “liquidity”); and you think that private deposit insurance would be a waste of time and essentially worthless because you can’t completely rely on insurance companies. So what exactly do you want?
Laird:
No, I’m not tepidly in favour of anything. State deposit insurance is a guarantee of liquidity and as I said, I am not in favour of it. If you don’t understand what liquidity is and how state deposit insurance works, I don’t think I will be able to ease your confusion.
Exactly what I said above, which, for some reason, I’m being asked to repeat ad nauseum.
I know very well what liquidity is and what an asset/liability mismatch can mean.
I don’t think you understand how insurance underwriting works. The “whole purpose of insurance” is for the risk taker to transfer, not abdicate risk. The insurance underwriter evaluates the activity and if he thinks the terms are acceptable, he assumes the risks in exchange for a payment. It doesn’t take “skin out of the game”, it transfers it to an underwriter who assumes it voluntarily if his terms are met. Private insurance turns the insurance underwriters into the banking regulators. Underwriters do have skin in the banker’s game.
Sorry to be dense, but the only statement I can find describing what you want is “I do not support the concept of state deposit insurance; I am not in a position to change the system, but if I were, I would phase out state deposit insurance.” Is that it? All you want is to eliminate government deposit insurance, replace it with nothing (since private insurance is worthless) and otherwise leave the banking system as it is? In other words, return to pre-1933 (or better yet, pre-1913) banking? Because if that’s what you advocate I’m OK with it (I would just add to option of private deposit insurance for those who want it and think it has value.)
Laird, that’s about the strength of it, although I wouldn’t be in favour of a return to the gold standard which tended to exist in banking systems at that time.
The one additional thing which I think may be required is an obligation for banks to publish an irrevocable resolution plan, stating who gets access to money when in the event of a liquidity crisis, but that’s a relatively minor issue.
Yes, that is a minor issue. But I would want a gold or some other external standard. Politicians cannot be trusted with anything as important as money.
Laird:
I’d say, if you want gold, buy gold.
Maybe, but as long as there is a state which taxes, the state will have to mandate a form in which taxation is paid and for all its faults, fiat currency is the best option. Mandating the payment of tax in the form of a specified metal is both wasteful (requiring that metal is mined in order to put it in a vault) and a form of state welfare to the holders of whichever metal is chosen.
That’s a different discussion.
Paul : “as long as there is a state which taxes, the state will have to mandate a form in which taxation is paid and for all its faults, fiat currency is the best option”
Steady on there ! Tax is just a debt. A debt can be payable in anything. Where the debt arising from a contract, the parties can define how it is to be measured and settled. Tax is only different in that it doesn’t arise from a contract and the creditor alone gets to specify how it is measured and paid. But it is an enormous leap then to concede that a fiat currency is required (or is the best option.)
Absent fiat currencies there is still a vast number of monetary options. Gold and silver have been used historically, but with modern technology and financial knowledge, there are plenty of other options (and I’m not talking bitcoin.) The most obvious would be to specify a basket of goods and services (a la RPI) and define “one pound” as say a millionth of the basket. A tax debt of £500,000 could be settled in anything equal in value to one half of the basket. Some people might prefer baskets of investment goods – say the FTSE 100. Banks could establish their own baskets and issue banknotes accordingly. Sure the goods and services that make it into the basket that the government specifies for tax calculations are favored to some small extent, but so long as it’s a big basket, hardly enough to disrupt prices significantly.
What that sort of currency (or set of currencies) lacks, in comparison with either fiat currency or gold, is simplicity. But the complexity doesn’t need to trouble everyday users – working out and valuing baskets can be done by big clever computers.
I do not say that this is the best answer, since I am not the cleverest person in the world (by some distance) and I have devoted all of ten minutes thought to it. But I do challenge that idea that if you have a state which levies taxes – ie if you have a state – you really have no option but to have a fiat currency.
Lee Moore:
I didn’t say that a fiat currency is necessary, just that it is the best option.
“I didn’t say that a fiat currency is necessary, just that it is the best option.”
Because ?
It has the lowest cost of production and doesn’t involve any state welfare.
But the low cost of production is one of the biggest problems with a fiat currency ! The money printer has an economic incentive to continue production until marginal revenue equals marginal cost – ie keep inflating until the exchange value of the currency equals the cost of production. Since the fiat currency note isn’t convertible into or linked to the value of anything real there is no incentive to stop printing. And the story so far shows that no one is able to resist the temptation.
Whereas my basket currencies – which I concede have a cost of production almost as low as standard fiat currencies – are in substance depository receipts for things that do have a substantial cost of production, and hence do not present the same temptation to inflate. The same goes for gold depository receipts.
So what?
It isn’t really true, as generating huge inflation creates problems for the state, but that aside, even if it were true, I wouldn’t view it as a major problem.