Why Some Banks Should Go Bust

The financial sector should not expect always to be bailed out by government...

LET'S take a look at the current state of democracy in the European Union, writes John Phelan for the Cobden Centre.

Last week the Cypriot parliament voted down a proposal to secure the €10 billion funding needed to bail out its crippled banks that would have imposed a one off "solidarity levy" of 6.75% on bank deposits under €100,000 and 9.9% on those over. 

This week the Cypriots were offered the money in return for a deal which shuts the second biggest bank and scoops up €4.2 billion from uninsured deposits and moves the insured deposits (under €100,000) to the Bank of Cyprus where deposits over the €100,000 will be taxed at 40%. The Cypriot MPs, from Churchill to Quisling in seven days, accepted.

The counterproductive stupidity of the proposal has been widely noted. It's difficult to see how the aim of shoring up Cypriot banks which have had their capital bases ravaged by haircuts on Greek government debt will be helped by a policy which is almost certain to cause a run on those very same banks.

But the strongest reaction was moral outrage that the Cypriot government, at the behest of the troika, was considering simply helping itself to its citizen's cash. Personally I'm unclear how this is morally different to what governments do all the time. Indeed, in the age of the welfare state, big government, and redistributive tax and spending, it has become the governments raison d'être to do exactly this day in day out.

But we shouldn't dismiss the idea so quickly. It stems from the notion that banks act as warehouses for deposits; that we go to the bank, make a deposit, and that that deposit sits there until we go back to the bank and take it out. Of course, under a fractional reserve banking system it doesn't work like that at all. Just like the garage attendants who took Ferris Bueller's Ferrari for a joyride round Chicago when he left it in their care, bankers lend multiples of our deposits straight out the back door as soon as we've taken them in the front door. Deposits in banks are not like sticking your money in a safe; rather they are "loans to highly leveraged businesses"

You might say that no one actually thinks on that level when they deposit their money in a bank. Well, firstly, why wouldn't they? The very fact that a bank pays interest on deposits (however small that might currently be) should be a warning sign that they are not merely humble warehouses. Ask yourself, how many warehouses pay you for the privilege of storing your stuff? They don't because a warehouse has operating costs; it needs a building, it needs staff. It has to charge the people who leave stuff there, its depositors, a fee to cover these expenses.

A bank also has operating expenses; it too needs the buildings and the staff and much else besides. Yet, as the bank takes in your deposits and incurs these expenses, unlike the warehouse it pays you. It must, therefore, have another source of income, and it does; the yield on its assets, assets bought with your deposits. The bank is able to pay you interest because it is accumulating assets with your cash; the bankers are taking the Ferrari for a ride. That banks pay interest on deposits proves that they are not simply warehouses.

Secondly, are we sure that people don't act like that? As a personal example, my old flatmate's mum had money in Northern Rock and when it hit trouble she demanded a bailout. "Why did your mum put her money into Northern Rock?" I asked "Because they offered good interest rates" she replied.

Of course they did. That's because their funding model, lending long term at typically higher interest rates with money borrowed short term at relatively lower interest rates was, ultimately, as risky as it sounds. Many Cypriot banks were offering rates of a relatively healthy 6% or more, but then they were investing 160% of Cyprus' GDP in Greek government bonds.

One of the first things they teach you in GCSE Business Studies is that profit is the reward for risk. The high interest rates offered by Northern Rock and the Cypriot banks were indicators that they were engaged in something relatively risky. If you choose to take that risk on then I wish you all the best, but you should not expect a taxpayer bailout when things go sour to turn your investment into a one way bet; heads I win, tails I don't lose. 

The idea that governments must bail out busted banks is rarely questioned nowadays except by those who wish to be labelled some sort of economic 'extremist'. In his book 'How Capitalism Will Save Us', free marketeer Steve Forbes has four index references to Joseph Schumpeter and 14 for creative destruction including one saying that "Washington should have let GM and Chrysler reorganise under existing bankruptcy laws". Yet he answers the question of why the bailout of Detroit was wrong and that of Wall Street right by saying "The bailout was a necessary evil to avoid a collapse of the global economy". Capitalism will not save banking, it seems. 

But government bailouts of busted banks turn the investment that depositing is under fractional reserve banking into a no lose situation. This encourages risky investing and is how shaky banks become 'too big to fail'. Goldman Sachs and JP Morgan were bailed out five times in the 20 years before 2008 so why wouldn't they pile into subprime mortgage debt?

What is happening in Cyprus is undoubtedly a terrible situation for all involved. But if anyone is going to stump up for the bailout of Cypriot banks, isn't it both fair and sensible that those who do are their investors?

Get the safest gold and silver at the lowest price possible on BullionVault...