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Andrew Lilico: When a bank goes bust, should insured deposits be more protected than uninsured deposits?

If a retailer like Woolworths goes bust and the company is liquidated, there has, since the Bankruptcy Act of 1542 been a hierarchy of claims on the fruits of liquidating that comany's assets. These days the order is as follows. First the "secured" creditors (e.g. those that had lent money secured against a particular sort of machinery or a car) take their cut, then salaries, the the creditors termed "senior unsecured" come next, then "junior unsecured" creditors, and whatever is left over (if anything) goes to the shareholders. At any point in the hiearchy, you have no claim until more senior claims have been satisfied in full, and if you take a haircut everyone that ranks equal with you takes the same haircut.

In a number of countries in the past, if a bank went bust, depositors ranked ahead of (were "senior to") bondholders. So no depositor would lose anything until bondholders had been completely wiped out. But in Britain, as of 2008, legally depositors and bondholders ranked equally. One of the recommendations of the Vickers Commission was that depositors should have what is called "preference" over bondholders - i.e. that in future they should be senior to bondholders, as in certain other countries. This concept has been taken up at EU level, and is currently under debate.

One sticking point in negotiations over depositor preference concerns the status of insured depositors. The British, represented by Chancellor George Osborne in recent negotiations on this point, wanted insured depositors to rank ahead of uninsured depositors. A number of other European leaders wanted insured and uninsured depositors to rank equally.  In my view the British position is wrong, and that of other EU leaders correct.

To see why, let us consider two cases: the treatment of depositors in Cyprus in the recent "bailins" of the banks there, and the level of deposit insurance in the UK in 2007. In theory, in Cyprus the way EU deposit insurance should have worked was as follows. Insured depositors would share in the haircuts experienced by other depositors (and, as it happens, bondholders), but then be compensated by the national deposit insurance scheme. It doesn't really matter for our purposes whether the insured depositor would be aware of being compensated - the issue isn't whether anyone has to "claim back" after initially being out of pocket, or anything like that. We can assume that the national deposit insurance scheme seamlessly and instantly transfered the compensation into everyone's account. Neither does it especially matter for our purposes whether the national deposit insurance scheme is funded by other banks or by the government.

What does matter is this.  In Cyprus "insured" deposits weren't insured as such at all - partly because the Cypriot government didn't have enough money to cover them. Instead, they were made senior to other deposits, as per the British proposal for what should apply across the EU. The consequence of that was that other depositors experienced much larger haircuts than they would have experienced had the insured depositors also taken a haircut and then been compensated - perhaps twice as high a haircut.

So far so straightforward - that is obviously a consequence of making insured deposits senior to uninsured deposits. But now grasp this: the amount of the extra haircut experienced by the uninsured deposits depended on the level of deposit insurance. If instead of being €100,000 the deposit insurance level were €50,000, uninsured deposits would have taken a much smaller haircut, whereas if the insurance level were €200,000 the uninsured deposits would have taken a much larger haircut.

Again, that's obvious, but it's crucial, because governments change deposit insurance thresholds quickly and arbitrarily, as we can see by considering the UK in 2007. Up to September 2007, only £2,000 of deposits were 100% insured. That suddenly went to all deposits placed in any bank after an arbitrary date, then settled back to £50,000 in October 2008, then rose to £85,000 in 2010. If insured deposits were not preferential to uninsured deposits, rises in the deposit insurance threshold would affect only the insured depositors - making them better off. But if insured deposits are preferential to uninsured deposits, then rises in the deposit insurance threshold make uninsured depositors worse off. So you could deposit £1 million in a bank believing the interest rate it offered you provided a reasonable compensation for the risk of any plausible haircut you might experience if the bank went bust, but then find that, because the government raised the deposit insurance threshold, what had seemed like a fair risk suddenly turns into a very bad deal, not because you have mis-assessed the riskiness of the bank but instead because you were the victim of a regulatory policy change.

That would be bad for the use of market forces to maintain banking stability. It would mean that when a bank started to become riskier, it could not compensate by attracting deposits by raising interest rates, because large depositors would be concerned that the government would respond to the bank's distress by raising deposit insurance thresholds after the large deposit was made, confiscating funds ex post from uninsured depositors. (And raising interest rates would make no difference to insured depositors, since they would be insured anyway.)

It would be better not to insure the capital value of deposits in fractional reserve banks at all. But if they are insured, and if we are to have depositor preference, all depositors should rank equally. Otherwise uninsured depositors become subject to confiscation of funds through arbitrary (and plausible) regulatory decisions, which is not good for healthy market processes in banking nor financial stability.


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