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All of Draghi’s horses – thoughts on banking union and the Cyprus ‘solution’


Published on Eurointelligence on 28 March, 2013. Some discussion on the blog European Tribune.

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king’s horses and all the king’s men
Couldn’t put Humpty together again.
— traditional English nursery rhyme

“The central bank defends the payment system every day, every hour, every minute.” Scott Fullwiler[1] calls this “the fundamental truth of central bank operations” and I will call it the essence of monetary union.

The usual institutional arrangement in monetary economies is that payments are made in state-issued currency, or by means of credit instruments denominated in a state currency serving as the unit of account. in advanced economies banks provide the essential infrastructure of the payments system: they operate the channels, namely branches and ATMs, through which people and firms obtain cash; their demand accounts provide a store of value; and they provide their customers with payment instruments such as debit cards, or also credit-based instruments such as cheques and credit cards. Just as banks guarantee their customers’ credit, backed by the customers’ bank deposits, when issuing to them widely acceptable payment instruments; so the state guarantees the credit of the banks in relation to their customers’ demand deposits, through deposit insurance schemes. All of this must be relatively transparent to the public if the payments system is to function effectively. Deposit insurance was, in fact, invented to prevent bank runs and you cannot have just a bit of it: it must be total up to a certain amount. The UK tried to have only partial deposit insurance and we saw how that turned out with Northern Rock in September 2007.

In addition to this, the central bank acts as a clearinghouse for payments among banks, which comes into play every time two people use means of payment issued by two different banks to mediate an economic exchange between themselves. Central bank liquidity provision and lending-of-last-resort actions exist to protect the bank clearing system and thus the overall payments system. This is the meaning of Scott Fullwiler’s dictum above, and the ‘zeroth mandate’ of central banks even if their charter say their first (and maybe only) mandate is price stability, for there can be no price stability without a stable payment and clearing system.

Similarly, for international payments the BIS in Basel acts as a central bank of central banks. In the Eurozone the Eurosystem acts as a clearinghouse between Eurozone central banks through the TARGET2 system, and the ECB defends the stability of the payments and clearing system by means of its ordinary, and currently quite extraordinary, liquidity provision. The ECB may talk about broken monetary policy transmission channels but what should keep them awake at night is the possibility of a broken payments and clearing system.

It is thus not unreasonable to argue that, in a monetary union with free movement of capital and electronic means of payment, deposit insurance should be union-wide. If it isn’t there is a risk of bank deposit runs or destructive zero-sum games, as seen when at the end of 2008 the IceSave fiasco and the Irish blanket bank guarantee forced the EcoFin to harmonise deposit insurance[2]. Even then the choice to mutualise Eurozone bank deposit insurance was rejected, and lo and behold the issue resurfaced again in the banking union debate in the second half of 2012.

Deposit insurance is a state guarantee of the banking business and a recognition that banks are service providers of the public good of a payments system. Such a state guarantee requires regulation and supervision if moral hazard is to be avoided. Again, if liquidity provision and deposit insurance are to be mutualised, then it is reasonable that bank regulation and supervision should also be mutualised. Whether or not the banking supervisor is the same central bank that provides liquidity, there is an obvious synergy between the two functions and so-called Chinese walls between the two would prevent either from being effective. In the throes of the Greek sovereign debt crisis in 2011, Guntram Wolff of Bruegel[3] argued

“The ECB – providing a large part of the infrastructure of the ESRB – knows which banks use Greek bonds as collateral for the open market operations and should therefore have a good picture of exposure to Greek bonds. The ECB should also have fairly detailed information on the interbank market, from which contagion across banks can be assessed.”

The Eurozone would therefore be handicapping itself it it prevented the ECB in its capacity as liquidity provider from sharing information with whichever institutions are responsible for bank regulation, supervision and resolution.

In addition, deposit insurance requires the ability to intervene an insolvent institution and to summarily put it into receivership or restructure it. In the US the FDIC has been doing this for 80 years, for thousands of banks[4], though apparently unbeknownst to the US President[5]

“Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks.”

The example of the FDIC makes it inexplicable that the fact that there are a few thousand banks in the EU is used as an argument against EU-wide deposit guarantee and bank resolution by people who should know better.

An ordinary judicial insolvency or liquidation process seems to be inadequately slow for banks, which is why special resolution regimes are needed. Such were advocated, for instance, by Joseph Stiglitz[6] (who called them ‘super-chapter-11’ by reference to US bankruptcy law) in light of the experience of the late 1990s Asian and Russian currency crises. The case of Lehman Brothers showed that nondepository institutions might also require a speedy resolution scheme which the FDIC could not provide and which 4 years later is still not in place. In Europe a special resolution regime for banks is in the cards, but so far it appears that only Spain has anticipated such legislation, and only under duress as a result of the July 2012 Memorandum of Understanding.

In sum, the case seems compelling for a Eurozone-wide clearing system, liquidity provision, deposit insurance, banking regulation and supervision, and a special resolution scheme for banks. The case is underpinned by the necessity to provide a unified and efficient payments system for the currency area, and the need to ensure its safety and defend its integrity. Arguments against joint supervision hinder the Central bank in distinguishing between illiquid and insolvent institutions. Polemics against joint deposit insurance actually foster cross-border deposit runs. And rhetoric against Target2 undermines the integrity of the payments and clearing system itself.

The Target2 ‘issue’ dovetails with deposit insurance because the whole point of worrying about Target2 is that, in case of a Euro breakup, the Bundesbank might not be able to recover its claims on the Eurosystem. However, these claims are, at least partly, balanced by nonresident deposits in German banks. As Paul de Grauwe[7] has pointed out, that problem would be solved if, after a Euro breakup, the Bundestag removed deposit insurance for nonresident deposits. In addition, Karl Whelan[8] has argued that even a Euro exit would not necessarily entail a repudiation of central bank debts to the Eurosystem, precisely because of its role as a clearinghouse for cross-border payments. Nevertheless, to the extent that German Target2 balances reflect peripheral residents taking their deposits abroad rather than German residents repatriating their foreign holdings, much clarity would be achieved if those banks taking full-page ads[9] encouraging Chancellor Merkel to oppose Euro-wide deposit insurance instead lobbied the Bundestag to remove the umbrella of deposit insurance from nonresident deposits. It is not possible for a Euro member state to entertain Euro breakup, decry Target2 balances, refuse deposit insurance, and yet benefit from a panic in the deposit-taking zero-sum game. Or rather, it can be done but it’s not in the wider European public interest.

And so we come to the unfortunate outcome of the Cyprus crisis between the Eurogroup meetings of March 15 and March 25, 2013. The initial decision to bail in the insured depositors of Cypriot banks cast doubt on the commitment of those present in the Justus Lipsius building (finance ministers, Commissioners and ECB board members) to the integrity of the Eurozone payments system, and on their ability to act in the public interest. Probably the best one-liner was provided by David Zervos, who said[10]

“All of us should really take a moment to consider what the governments of Europe have done. To be clear, they initiated a surprise assault on the precautionary savings of their own people.”

With the move to ‘tax’ deposits below the €100k deposit insurance limit, on the legalistic argument contrived by the European Commission that if a tax is levied a minute before a bank fails in order to pay for a recapitalization the bank never failed and thus deposit insurance never came into play, the Eurogroup reneged on the October 2008 commitment to harmonize deposit insurance across the European Union. To go by immediate press accounts of the March 15 negotiations[11] [12] EU Commissioner Rehn and Cyprus President Anastassiades both made specific proposals taxing depositors under the deposit guarantee ceiling, and the ECB threatened to force the insolvency of the Cypriot banks which would have put the Cypriot government on the hook for €30bn in deposit insurance it could ill afford. Many people, German Finance minister Schäuble among them, have since attempted to exonerate themselves on the argument that they made proposals that left insured deposits unaffected. Nobody, least of all the ECB, appears to have warned of the implications of undermining deposit insurance. But in fact, to stem a bank run, Cyprus instituted a bank holiday which ended up lasting nearly two weeks and included capital controls in the form on a ban on wire transfers.

I would like to expand on the implications of the Eurogroup’s “assault on precautionary savings”. Ashoka Mody[13] has estimated that, in the OECD,

“at least two-fifths of the increase in households’ saving rates between 2007 and 2009 was due to increased uncertainty about labour-income prospects”

What this means is that, at times of economic uncertainty, ordinary people increase their stock of savings (precautionary savings are not savings for deleveraging, but to build ‘rainy day funds’). Mody observes that in 2010 savings rates dropped again, which we can speculate is due to the modest economic recovery that took place that year. But given that the economic conditions in the Eurozone since 2010, and especially in 2012, haven’t been all that good, with several countries in recession and a couple in outright depression; and given the unanimously gloomy official economic forecasts for the next year; it would not be surprising to find that households have again attempted to build up a rainy day fund in the form of liquid deposits at their local bank after the dates explored by Mody and his coauthors. The increasingly explicit threats by the Eurogroup to tax these deposits also beyond Cyprus can only encourage households to shift their precautionary savings away from bank deposits.

The final Eurogroup decision on Cyprus ended up restoring deposit insurance and imposing a resolution of only the two money-center banks in Cyprus, leaving the rest of the banking system initially untouched. However, the message that it was the political intention of the Eurogroup to liquidate Cyprus’ “business model” makes a run on the remains of the Cypriot banking system a near certainty, and indeed the Cypriot parliament legislated stringent capital controls. But the Cypriot capital controls not only ringfence the Country to avoid a capital flight: they also completely tear up the modern payment system that used to exist in Cyprus. For ordinary people there will be restrictions on cash withdrawals, on check cashing, on payment orders, and on the use of payment cards. But the capital control bill passed by the Cypriot parliament also allows the monetary authorities to limit interbank lending. In order to save the Euro, and in order to save Cyprus from a crippling capital outflow, the entire payment and clearing system in Cyprus has been destroyed. Not only the Eurogroup but the European Commission and the central banks involved are going along with this with only a meek statement that the capital controls should be lifted “as soon as possible”.

When Roosevelt’s Emergency Banking Act of 1933 instituted a multi-day bank holiday it was on the promise that when banks reopened they would be solvent, and the promise was upheld and most banks opened within 4 days. Nothing of the sort is being promised in Cyprus, although the banks have finally opened. Without a diagnosis of the underlying problem other that “the Cypriot economic model is unsustainable”, the problem with ringfencing Cyprus and dismantling its payments system “for reasons of public safety and security”, ostensibly to prevent an “uncontrollable outflow of deposits” is that it is not clear how the Cypriot and European authorities expect to fix the underlying problem in the very short time they’re buying themselves (supposedly 7 days).

Finally, it should give everyone pause that Eurogroup president Jeroen Dijsselbloem would characterize deposits above the €100k insurance limit as a risky investment earning a return

“… Because if I finance a bank and I know if the bank will get in trouble I will be hit and I will lose my money, I will put a price on that. I think that’s a sound economic principle. …” [14]

This completely ignores the fact that an important economic role of large deposits is to serve as revolving capital for firms of all sizes. Just like households have increased their “precautionary savings” in response to the recession, so firms may have increased their operating cash holdings in reaction to the contraction of trade credit that has accompanied a financial crisis lasting already 5 years. Have the European economic authorities thought out the impact that appealing to the “moral hazard” of large depositors as “investors” in “risky assets” may have on day-to-day functioning of the real economy?

In conclusion, even if an immediate bank run due to Cyprus is avoided in the rest of the Eurozone, will all of Draghi’s horses and all of Draghi’s men be able to put together the broken egg of public confidence in deposit insurance, and more generally in the Eurozone’s commitment to the integrity of its payments system?

[1] Fullwiler, Scott T., Modern Central Bank Operations – The General Principles (June 1, 2008). Available at SSRN:

[2] Ecofin Council, Immediate responses to financial turmoil – Council Conclusions (7 October 2008)

[3] Wolff, Guntram B., ESRB should act on sovereign risk, (May 5 2011)

[4] FDIC, Failed Bank List

[5] ABC News, Obama: No ‘Easy Out’ for Wall Street (February 10, 2009)

[6] Stiglitz, Joseph E., Globalization and its Discontents (2002) W W Norton & Co.

[7] De Grauwe, Paul and Ji, Yuemei, What Germany should fear most is its own fear (September 18, 2012)

[8] Whelan, Karl, TARGET2 and Central Bank Balance Sheets. University College Dublin. School of Economics, 2012-11.

[9] Handelsblatt, Sparkassen und Volksbanken treiben Merkel zum Kampf (September 13, 2012)

[10] Business Insider, ZERVOS: ‘This Is A Nuclear War On Savings And Wealth’ (March 17, 2013)

[11] Spiegel, Peter, Cyprus depositors’ fate sealed in Berlin (March 17, 2013)

[12] Steinhausser, Gabriele; Stevis, Matina and Walker, Marcus, Cyprus Rescue Risks Backlash (March 18, 2013)

[13] Mody, Ashoka; Sandri, Damiano and Ohnsorge, Franziska, Precautionary savings in the Great Recession (22 February, 2012)

[14] Financial Times, The FT/Reuters Dijsselbloem interview transcript (26 March, 2013)

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