Why a Deposits Haircut is a Terrible Idea

One of the newest ideas that the great masterminds of the European bail-outs have come up with is the one where a deposit haircut takes place, in order for the Cypriot state to assume less debt in the bank re-structuring process. Although we have not yet seen what such a proposal actually promotes (since it has also never been implemented in any country in the world), it would be save to assume something of the following according to Reuters:

People with deposits over amount X in a bank (although it has not yet been defined whether this would include just banks which need restructuring or any bank at all) would take a loss in order to make the banking sector smaller; this loss is expected to be compensated by new share issues. Reuters puts number X to equal €100,000.

The amount at first appears significant enough; not everyone can brag for €100,000 cash in their accounts can they? Yet, a closer look shows otherwise. A person who saves just €110 a month, assuming a 3% nominal interest rate, will end up with more than €100,000 in the bank after 40 years. Would anyone call such a person rich or well-off? I do not think so. It is more likely that this person plans to send his children to the university or live his later years live more easily with that amount.

Then, we should consider the risk assumed by the deposit-holder. Cash are unanimously considered as zero risk financial assets both because they are guaranteed by governments and because the initial investment is never at risk. If such a scheme is applied then we are essentially transforming risk-free assets to risk-bearing ones. What is more, we are transforming them into the second riskiest asset class (the first one being derivatives) there exists: stocks. Why would a person, who does not want to assume any risk, be willing to put money in the bank then if they are safer under the mattress?

In fact, a deposit haircut appears to be even worse than most austerity measures. It is a purely un-democratic proposal which aims precisely at allowing innocent people assume responsibility for someone else's fault. Austerity measures are usually promoted with the aim of reducing state expenses and affect the current income of workers; the deposit haircut is promoted just to save financial institutions and it affects consumer wealth. If we know that a decrease in government spending leads to a reduction in consumption and an increased rate of non-performing loans how can we even believe that the results of decreasing wealth will not have even worse results in the real economy?

As already noted, this has never before been implemented in any part of the world. If Cyprus, who under the English Law allows bondholders to sue the state for any debt haircuts, tries to implement such a scheme, results are bound to be devastating. In a 2010 paper on repo haircuts the authors conclude that (emphasis my own):

"Increases in repo haircuts are withdrawals from securitized banks - that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive and liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent"

Their results can be easily understood in terms of trust. If I do not trust that the bank will take care of my money and that they will be there when I need them why should I keep my money there? Then, if this does not hold for me, why should it hold for everyone else? Thus, we all refrain from keeping our money in the bank and we move to withdraw them; bank runs occur. With the enormous drop in liquidity the general economy also takes a tumble. For those who do not believe that such bank runs are possible nowadays I would point that Cyprus lost €1.7 billion in deposits during January, when this scheme was just a rumour.

The time for utilizing ESM funds has arrived. Although Mario Draghi put the markets at ease in September by saying that the ECB will do everything it takes to keep the euro alive, very few will still believe his words if they are not put into practice. The EU officials should be thankful that the opportunity to test the ESM came with Cyprus and not with Italy or Spain. If something does not work in the Cypriot case then the amount of money lost will be minimal compared to what would happen if Spain or Italy were assisted and things did not turn out as planned.

Again, let us not forget: our economic system is based on trust. If we cannot continue to trust the system then it will simply collapse.