The delusions of 100 per cent deposit insurance
The most fundamental ethical principles of capitalism are that no investment is without risk, and that the state does not exist to keep the rich rich. Indeed, capitalism – the system in which the provision of capital (i.e. debt or equity) is separate from the management of businesses – only got going from the sixteenth century onwards once it became accepted that charging interest (usury) could be morally permissible if there was genuine risk involved, and only flourished from the eighteenth century onwards as a system of restrictions was developed concerning what creditors could do to those that did not repay.
The most important form of capital provided to the banking system is deposits. Deposits in the kinds of banks we have in the UK are loans made to the bank. The interest paid on bank deposits is ethically defensible precisely because deposits are at risk. If the state intervenes to bail out depositors when the bank would otherwise default, it violates the second of our fundamental ethical underpinnings of capitalism, because the state then becomes a mechanism whereby the wealthy – those with large bank deposits – are kept wealthy by the government. The government taxes the poor to keep the rich rich.
Much current debate about banking reform appears to proceed from the initial assumption that it is unthinkable that any depositor could lose any money. Yet until 1979 there was no deposit insurance whatever in the UK (it came in only because it was required by an EU Directive). Even until 2007 only £2,000 was totally insured. We proceeded straight from only £2,000 being fully insured, and that only as a consequence of an EU directive, to it being unthinkable that any depositor could ever lose any money!
We could, of course, have a system in which the state guarantees all deposits 100 per cent, but in such a system it is the state that is the most important provider of capital in the economy (since it guarantees the deposits). That was the system in Italy and Spain in the 1960s – a system in which all retail deposit-taking was nationalised. It isn't impossible. It's just quasi-Communist. It certainly isn't anything remotely like capitalism. We could also have a system in which the state guarantees all deposits but deposit-taking is done in the private sector. So, because the main capital provided to banks is without risk, banks will engage in highly risky lending and investment practices – the shareholders and employees take all the upside when things go well, and the main debt-providers (the depositors) don't lose out when things go badly. Essentially, that's the system we've had in recent years – a system in which the wealthy take the upside when things go well, and those with fewer assets pay taxes to keep the wealthy wealthy at other times. Such bandit capitalism – confiscating from the poor to give to the rich – is possible. It just isn't particularly attractive.
Many politicians seem to imagine that there is something else – something other than bandit capitalism or quasi-Communism – that allows for 100 per cent deposit insurance. They fondly imagine there is some kind of regulatory solution. But there isn't. It's simply a delusion. A system in which regulators inspect and constrain all the activities of banks so completely that there is no risk whatever of the bank going bust and imposing losses on depositors is a system of state control every bit as extensive as nationalisation of retail deposit-taking. It is simply quasi-Communism by stealth.
This is doubly perverse, since unlimited 100 per cent deposit insurance is not merely ethically indefensible and economically destructive. It also achieves almost nothing. Many people seem to imagine that deposit insurance prevents bank runs. But when depositors run on banks, that isn't because they are scared of losing their money – it's because they are scared of losing access to their money. Even in the US banking collapses in the 1930s, typical recovery rates for depositors exceeded 80 per cent. One could lose 20 per cent of an investment in the stock market in a single day! But in the 1930s banking collapses it often took two years to recover one's money – by which time people had themselves defaulted on their mortgages on their houses and farms. Guaranteeing depositors' capital (the value of their deposits) achieves little; what they care about is their liquidity (their access to their deposits). Insofar as it works at all, deposit insurance does so via an implicit promise that the government won't let the bank shut down at all, and hence that liquidity is guaranteed.
It is sometimes a task of economists to tell politicians unpleasant truths that they would rather not hear – to puncture their fond delusions. That is the case here. There are important and valuable reforms proposed in the banking sector (in particular debt-equity swaps, of which I'll write more another time). But the key ambition of structural reforms to the banking sector should be directed at making it more possible that the government does not bail out depositors in respect of their capital but, rather, their liquidity. No reforms can succeed if they take it as axiomatic that no depositor can ever lose money. The widespread belief that they can merely serves to illustrate how little politicians (and journalists) really understand what a bank is.
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