Now that the dust has begun to settle in Cyprus, the battered principle of deposit insurance seems to be safe-for now at least.
In the big stare-down with the European Union the final Cyprus settlement did not zap the small depositors.
Instead it simply shifted the burden further up chain. The final deal increased the "haircut" on large depositors in the Bank of Cyprus and Laika Bank from an originally proposed 9.9% to an astounding 40%.
To me, that's highway robbery -- even if the Russian Mafia has to bear a big share of the brunt.
As strange as it may seem, even the Russian Mafia has rights!
The lessons here are quite clear...
The Trouble with Banking These Days
In the aftermath, all that has been accomplished is that banking has been turned even further on its head.
Traditionally, the deal with banks is supposed to be simple: The lenders and the shareholders are supposed to take the risks, while the deposits remain safe and sound.
For deposits under $100,000 or the foreign equivalent, there's generally a local deposit insurance scheme for depositors to fall back on. (Pretty useless in Cyprus, since the banks were five times the size of the country.)
On the other hand, larger depositors are supposed to check the credit standing of the bank before they make their deposit, but with stockholders and bondholders beneath them, there really shouldn't be much risk.
Unfortunately, banks no longer carry enough capital to make them truly safe.
In the days before deposit insurance, banks had capital of at least 20-25% of their assets, and their loans were much less than their deposits. As a result, depositors could rely on a pretty fat cushion before their money was exposed to losses.
That's not to say you were ever 100% safe. In a global calamity like the 1930s, a third of U.S. banks failed. However, in normal times you were OK.
Today there is no such protection. Theoretically, depositors should be able to rely on bank regulators to ensure the institutions are sound. But in practice, regulators are useless.
With modern off-balance sheet games proliferating, they don't really understand the business. They are also prone to being "captured" by the banks they regulate. Consequently, banks are allowed to "risk-weight" their assets before calculating their capital.
The most egregious example of this is that government bonds are allowed a zero risk-weighting. That means banks can leverage themselves ad infinitum with Treasury and Agency bonds.
But as First Pennsylvania Bank demonstrated in 1980, it's perfectly possible to go bust with a portfolio consisting largely of T-bonds. All you have to do is borrow short-term, buy long-term fixed-rate bonds, and wait for interest rates to go up.
As a matter of governance, large depositors therefore need more influence.
They need seats on the bank's Board of Directors, representation with the regulators or ideally both. Bank leverage is a great danger to them, especially in small countries with large banking systems, and if they are taking that risk, they should have a voice in its management.
The Lesson for American Depositors
For Americans, the lesson is clear. You can probably rely on the deposit insurance system, although for safety you should always choose a medium-sized bank which doesn't play fancy investment banking games.
However, if you have more than $100,000 in short-term assets, you're better off in a money market fund, where at least you get the benefit of diversification.
And even though the banks are trying to make the money market funds "break the buck" by reporting fluctuating net asset values that will panic savers back into the banks (they hope), the truth is net asset values won't fluctuate much.
When push came to shove, even the Reserve Primary Fund, which went bust in 2008 owning tons of Lehman paper, paid 99 cents on the dollar. Meanwhile, in a solid money market fund you're far less reliant on the bizarre profit-chasing shenanigans at a single institution.
So, are there other banking systems with Cyprus's problem?...
Sure. Luxembourg, for example, is tiny and has bank assets many times its GDP. It is equally used as an offshore banking haven, though generally with a rather better class of depositor --Germans, not Russian Mafia types.
And for a country with both bank and sovereign debt problems, try Slovenia. Slovenia has a large state-owned bank, Ljubjanska banka, which is still a near- monopoly and has never been sorted out from its Communist past.
When the country became independent in 1991, I was an advisor to the then-government. Boris Pleskovic, the prime minister's chief of staff, and I both said Ljubjanska banka should be broken up. Indeed, I went on Slovenian television for a 90-minute panel on how it should be done (this was in prime time; the programming values of Slovenian TV were old-fashioned, to say the least!).
However the good guys lost the subsequent election, Ljubjanska banka was never broken up, it went on making big loans to politically-connected companies and the government itself ran deficits.
As a result, even though Slovenia is quite rich, its banking system and state finances are both a horrid mess.
So what's going on in Cyprus is just a taste of what's still to come. Now more than ever you have to be careful where you put your money-especially if you're in the Russian Mafia.
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