A run on the banking system is one of the surest paths to a credit crisis. The mechanics are simple: worried that their banks might fail or otherwise endanger their savings, consumers shift to their mattresses as preferred storehouses for cash. The expectation fulfills itself. In a fractional-reserve banking system, mass withdrawals drive institutions to insolvency. A failure of one bank raises the possibility that others could also fail. And so the process cascades.
In spite of the obvious moral hazard, it’s no surprise that deposit insurance is the norm in modern banking systems. During an economic downturn, preserving the flow of credit to consumers and businesses is critical to steadying the ship. In the context of fiscal imbalances and badly needed austerity, moves that weaken credit intermediation may be especially counterproductive. In a puzzling move, policymakers on the Continent are now playing with fire. By undercutting the credibility of the guarantee in Cyprus, the European Union and International Monetary Fund risk fomenting instability and financial stress.
Bank runs were a central feature of the Great Depression. By March 1933, the system had largely collapsed. The holiday began in Michigan, where Governor William Comstock suspended bank operations statewide to preserve the Union Guardian Trust Company of Detroit. The public reaction diverged wildly from the government’s intent. Maryland was the initial vector of contagion, which soon spread to every part of the country.
On Inauguration Day in 1933, hotels in Washington, D.C., refused out-of-state checks and demanded cash. The immediate crisis reached a peak two days later when President Roosevelt declared a national banking holiday. He then took to the radio waves for his first Fireside Chat. The Emergency Banking Act came with explicit guarantees by the Treasury to the regional Federal Reserve Banks and implicit guarantees of deposits by extension.
A formal deposit insurance was not assured. President Roosevelt and his treasury secretary opposed the idea. The American Bankers Association proved one its staunchest detractors, demanding the president veto related legislation. When it was finally agreed to by Congress, his signature created the Federal Deposit Insurance Corporation.
Deposit insurance is a cornerstone of contemporary financial stability policy, even if its exact implementation is a source of disagreement. The Emergency Economic Stabilization Act of 2008 pushed the deposit insurance limit from $100,000 to $250,000. Bankers and policymakers who contend that Dodd-Frank is either completely ruinous or completely helpful are motivated by ideology. Among the act’s more benign provisions, it made permanent the higher insurance limit.
For deposit insurance to have its intended effect, it must be credible. In the United States and most other modern economies, it is. Thousands of banks have failed since the creation of the FDIC—but not one depositor has lost a dollar. Even in the darkest days of the credit crisis, there were no lines outside our bank branches.
The case of Cyprus is unusual. Public debt is relatively low in relation to the size of the economy. On the other hand, bank debt is egregiously high; as of 2010, its non-financial debt in the private sector was second only to Ireland’s among European Union member countries. The euro zone and IMF response to the Cypriot crisis is not unusual so much as it is bizarrely self-defeating.
The cost of the Cypriot bailout has been pared down to 10 billion euros, largely at the expense of savers. As of Sunday, insured deposits will take a 6.75 percent cut. By reneging on its commitment and replacing deposits with bank equity, the government of Cyprus is penalizing savers and rewarding illiquidity. Of far greater concern, the euro zone and the IMF have set a precedent about the violability of contracts with depositors. Central bankers and finance ministers will argue the circumstances are unique, but their loss of credibility is enormous. As a flash point for a renewed crisis in Europe, it’s the butterfly that threatens a wider storm.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.