Bank Deposit Guarantees: an alternative approach

by George Hatjoullis

The bail-out of banks, despite popular myth, is entirely related to protecting bank depositors (who I should add are typically also tax payers). The consequences of not doing so can be understood by the recent experience of Cyprus banking and has been covered in many of my previous blogs. Deposits are either insured or uninsured. The convention has been that uninsured depositors of large banks should be protected if a systemic crises is possible. In practice, all crises are potentially systemic and the result has been that the uninsured depositors of large banks (too-big-to-fail) are usually protected through government, and thus tax payer, intervention. Cyprus is a notable exception.

Insured deposits are assumed to be protected by the deposit protection agency. This is industry funded but in a systemic crisis the fund may be unable to meet all losses so tax payer intervention might be necessary. The conventional protection architecture is back-stopped by the tax payer. The experience of 2008 has made this arrangement unpopular and a great deal of regulatory work has gone into removing the tax payer from the equation in a systemic crisis. Nevertheless, however much capital  or loss-absorbing debt banks hold, it remains possible that a systemic crisis could threaten the value of deposits. This is certainly true of uninsured deposits but also potentially of insured deposits. If depositors fear losses their reaction can create chains of events that the state may find hard to control without stepping in with tax payer capital. There is an alternative that only Iceland seems to have discussed.

Cash is always desirable in such crises. This is because it is issued by, and thus a liability of, the central bank. If you get your cash out of the bank you will always have the nominal value of the deposit, come what may. The problem is, as many Cypriots discovered, where do you hold it safely and how do you effect payments with it? A bank deposit is a just a loan to a bank and if the bank is in trouble this can potentially be lost. An insured deposit depends upon the fund and ability of the government to make good the insurance. In the eurozone this is problematic as the government may have insufficient euros. It is an independent ECB that prints euros and member states have no control over this process. The solution lies with the ECB. What if individuals are allowed to hold deposits with the central bank?

Holding a deposit with a central bank is nothing more than digital cash. It cannot be lost because the CB can always print more. It is just a (digital) ledger entry. A CB deposit could be introduced through banks and operated through the bank clearing system. It could be just like a current account. The only difference is that it would be a liability of the CB, and thus safe, and not a liability of the bank through which it is held. Deposits with the bank would be risky and presumably command a higher interest rate. CB deposits would typically carry no interest and may even involve a charge. The important point is that concerned customers do not need to queue up to withdraw cash. They make a digital transfer into their CB account. Of course, they may be too late but that could also be true in queuing for cash.

The CB account provides a truly risk free asset in times of systemic crisis. The mere existence of such an account can have a stabilising effect. If the bank fails, CB deposits are safe. It is still conceivable that not enough would be held in such deposits or could not be transferred in time. However, it is less likely. Most important it allows the payments system to continue to operate through the CB deposits. This alone would be a huge gain. One of the most serious economic consequences of a systemic banking crisis is the failure of the payments system. No one can get paid so economic activity comes to a halt. The CB accounts would exist and provide a mechanism for payments. Failed banks would stay open to allow the payments system to operate even though they could not make new loans. The existence of a payments system would also help banks collect and meet payments. The skeleton of the system remains in tact even though the volume would be diminished.

The introduction of a CB account need not affect any other operations. The banking system could continue as it is now. The account would give the CB another way of influencing the economy. It could encourage/discourage deposits in CB accounts through interest rate variations. If it wishes to discourage credit expansion it could raise interest rates on CB deposits. This would have a direct impact on all bank deposits and loans. CB deposits would not be available to commercial banks to use for lending. The CB would not lend directly to the private sector. Purchases of private sector assets in the secondary market in QE operations would still be possible. The key point is money in this account is 100% safe in nominal terms, though even indexed accounts could be introduced. No one needs to insure it or guarantee it.