Why ELA is not Different from Bank Deposits

Truth is, when most of us hear about Emergency Liquidity Assistance (ELA), our minds go back to March 2013 when the Cyprus haircut was first announced; we think of ELA as a trouble indicator, one which signifies that a bank is desperate enough to obtain it from the Central Bank, and subsequently, that the bank which obtains it is about to collapse. Yet, even though some parts of this story are correct, both the conclusions usually reached as well as the consequences we think ELA funding has, are, most of the times, unreasonable.

First things first: banks operate with deposits and loans, with the available money in the economy. In addition, they also tend to create money themselves, by the power of credit. What basically happens is that banks, using liquidity (i.e. available money) from their deposits, loan out funds to people. This occurs until the regulatory capital requirement hits. What liquidity means though, is that banks cannot perform their day to day business without money. Imagine going to a bank only to find out that it has run out of money, just like what happened in the US during the Great Depression or in the UK during the 2008 crisis. In order to avoid panic, the Central Bank usually steps in when there is a large outflow of deposits providing liquidity to its banks.

Here's what should be noted though: running out of liquidity is nothing unusual for banks. That's why interbank loans and discount windows exist. In the first case, the bank obtains a short-term loan from another bank with more liquidity available in order to maintain a minimum until more money are returned (via deposits or through loan installments) while in the second case, the same occurs but the bank borrows from the Central Bank. In both cases, borrowing from either source actually has less cost for most banks, especially in the periphery (in countries like Germany and the UK, the interbank lending rate is usually very close to the deposits rate).

Thus, what liquidity needs mean is that there is a positive shortfall in the assets minus liabilities, and the bank has to cover it; whether this cover-up comes in the form of deposits or interbank/Discount window loans is irrelevant to the bank. Banks however, deal with other banks the way they deal with other customers: if they do not believe that they will repay, then they will not lend. Hence, when banks are not very stable (and this might just be a perception not reality), other banks might refuse to lend them forcing them to turn to the ECB discount window (the same might occur if a bank just thinks that it might need a large amount of funds, regardless of its state). The only issue here is that banks have to provide some collateral in order to receive the loan. This collateral is usually in the form of government bonds; when the bond has been rated as garbage, the bank cannot offer it for collateral.

At that time, the ELA comes in play: the National Central Bank (NCB), which usually operates in a strange dependent/independent relationship with the ECB, offers lending and accepts other forms of collateral (e.g. loans). The reason behind this lending is simply that the National Central Bank does not wish for the specific bank to bankrupt, as the costs will be much higher than the benefits (note: the decision of whether to offer ELA or not is 100% up to the NCB. Still, Central Banks do not enjoy making the decision of whether a bank will bankrupt or not so they just offer the funds. Nevertheless, this is not a bad policy in general). While this is a burden for the bank, it actually is much better than the alternative, i.e. deposits. Given the perception (either wrong or right) that the bank is in trouble, it will have to offer huge deposit rates to attract customers; in Greece and Cyprus rates often exceeded 4 or 5%. In contrast, the ELA is offered at Euribor plus 1-1.5%, a total of less than 2%.

We consider ELA to be troublesome because it is a loan, and because liquidity is something we usually do not understand. How can ELA lending be decreased? Simply by bonds moving from garbage to investment grade categories allowing banking institutions to access the ECB discount window (which is just cheaper, otherwise it is just as lending as the ELA), by regaining the market's trust and have more people trust their money to the bank or simply by increasing the money in the market thus increasing liquidity. The latter can only take place through increased bank lending, something which needs both willing lenders and willing borrowers.

If anything, ELA just signifies trust in the bank: if we believe that the bank is going to make it, then it will be able to repay ELA money with no trouble at all. If we do not and the bank does not receive any deposits or more so money are withdrawn, then the bank will not be able to repay. The same holds from the Central Bank side which is really out of options: it cannot really withheld ELA and allow the bank to fail (see Lehman Brother and the steps taken by the Fed afterwards).

Deposits and ELA are materially the same thing for the bank. It's trust which distinguishes between the two; market's on one hand and the Central Bank's on the other. If the latter is regained then the bank survives; if not then it fails. In any case, ELA has nothing to do on whether the bank is viable or not in the future.

The Irony behind NPLs and Lending

This post could actually be summarized in one sentence: If you want Non-Performing Loans (NPLs) to fall, then you have to increase lending. Still, I don't really hope that I will be able to convince many just by stating this. Thus, what follows is an exposition of why the amount of loans (and more so of new lending) matters when it comes to NPLs and, in addition, when bank regulatory capital requirements are concerned.

NPLs are loans for which "payments of interest and principal are past due by 90 days or more". There is nothing more rational than to think of the rise in NPLs as an outcome of the crisis. This, nevertheless, is where most stop their arguments; the problem is that asking "why?" matters the most when it comes to policy. The answer is again so simple everybody has thought about it: it's because people lose their jobs and cannot repay their mortgages or other consumer loans, because there's no investment and no consumption forcing businesses to default and putting more people on the dole. 

The correlation is obvious as can be seen in the case of Greece:

Source: CEIC Network

NPLs as a percentage of total gross loans. Source: Index Mundi

The additional problem here is that crises usually come around when banks are already contracting their balance sheets, so the hit in consumption and investment is even harder: less consumption, less demand and less money to go around as well. As a consequence, firms face serious trouble meeting up with their obligations. If they cannot make ends meet, then their loans enter the NPL category. When more NPLs are created, then the bank is more constrained by its regulatory capital needs as bad loans are assigned a higher risk weight than before. Thus, the higher the NPLs the lower the banks' ability to lend out more money.

The problem resembles the one of austerity: we need a government budget surplus but we cannot do it since by cutting expenses and transfers (e.g. pensions) we are reducing consumption and thus government income. Similarly, we want smaller banks, but we cannot do it without retracting money from the economy. As money is reduced, consumption and investment become more scarce and business struggle for survival; many go bankrupt. Driven by this lack of funds, unemployment rises resulting in even more NPLs.

How can we get out of this mess? The solution (ironically) is not that banks have to decrease their exposure. It's that they have to increase their lending in order to get the economy going again. If the economy does not have enough funds to pull itself out then countries experiencing these issues will face Greece-like situations: prolonged measures to make things better, but only making them worse (here's looking  at you austerity!). When lending is increased then more investment is created; subsequently, more jobs and more consumption, leading to an increase in income and a decrease in the loans which cannot be repaid. When people have more money, loan payments which could not be paid before are met now. Nobody wants to lose their house, and no bank want to be stuck with one. In addition, less NPL's actually mean less capital needs, thus more funds to lend, thus more profit for the firm. Still, instead of lending and preventing this from happening, banks are forced by regulators (and themselves as well) not to lend out funds.

As said before, there is a time and place for everything. Just like it wouldn't make sense to continue expanding fiscal policy in a boom (see the UK experience), or performing QE operations when times are good, it does not make sense to use austerity measures when times are bad (Greece, Spain, Italy, Portugal, Ireland). Similarly, banks should not be pressured to reduce their credit exposures during downturns. Yet, unfortunately, policymaker decisions do not appear to be counter-cyclical.

Banks vs SME's: Who's the economy after all?

The title of Wikipedia's article on the crisis stars with a word which sums it it all up: Financial. What this means is that unlike others mishaps of the past, this time the trouble was mainly brought by financial institutions who could no longer survive. And since banks are not just like any other institution in the economy (in the sense that they provide the service of moving funds from one place to another, addition to lending) their importance was not big news to most (it was to some who believed that rescuing them was bad. Truth is, if Bernanke hadn't then we would be far worse than the 1930's).

In Europe, even though some of the troubles in the periphery are attributed to excess government spending, the truth is that the financial sector has also been a major cause of pain in at least half the economies in the EU (note that it has also been a problem in the UK, Germany, the Netherlands and Belgium, countries which do not often get the bad publicity of being in trouble). As in the US, governments in the EU rushed to save the banks, in most of the times with good reason. Yet, the emphasis on the banking sector has not stopped there; policymakers' preferences shifted to paying more attention on what the banks need instead of what is necessary for 99% of Europe's businesses: SMEs.

Unlike large businesses, who usually have ties with multiple banks, usually both domestic and abroad and have open lines of credit reaching hundreds of millions, SME's are faced with small business loans and very small credit balances. The increased capital requirements forced on banks and the now extremely picky procedure for securing a loan has brought many SME's to their knees. As the number of loans to the private sector is reduced, the SME owner finds himself without any sources of funding; while the data show that banks are doing better with regards to their loan portfolio, the market has in fact been suffocating.

The sad truth is that while we favour the survival of banks, we should remember that these institutions are mere intermediaries; it is true that the economy will freeze if banks collapse, but the same will occur if more and more SME's bankrupt day after day. Big businesses do not see their lines of credit diminished, but those who count the continuance of their day-to-day operations on checks who take days to clear, struggle with the reality of dying any time soon. Troubles are many, starting from the number of days required for a check to either be returned or cleared varies significantly among countries, (when it could essentially be done in less than a day in most), the increased fees required by banks to either send money abroad (even though SEPA is a major improvement) or to maintain certain accounts and finally the lack of any additional funding are major causes of headaches for people who do not have.

Since the emphasis is on the banks and not on the businesses, confidence that the economy will do better in the future is hard to build. How can the average Joe (and it is on his spending and his investment that we really count on) be convinced that things are doing better when he sees his company in the red, his friends and associates losing money and the business environment he lives in become harsher every day? We cannot de-emphasize the importance of banks but banks are nothing more than a small part of the economy; and since lending is limited (even in the best case scenario) we cannot be just focus on them and expect everything to go better.

I've said it before: we are at the ZLB so monetary policy is out of the question and our governments are constrained on spending making fiscal policy is not an option. All we are left with is confidence; yet, it cannot be raised if banks will not lend and make life miserable for millions across the continent. Yes, we need banks for the economy to move; but banks and the economy need businesses even more if we are ever going to see better days.

ECB's OMT, QE and why they won't matter

The biggest news on Friday was that the German Constitutional Court had passed on the examination of whether the Outright Monetary Transaction (OMT) scheme proposed by Mario Draghi in August 2012 was legal under the ECB mandate, to the European Court of Justice. This story was considered as a win by most on the pro-ECB camp, under the assumption that the ECJ would actually approve the scheme. The problem is that whether it does or not, it makes no difference. 

As Frances Coppola noted at the time of the Draghi announcement (and has recently repeated to all those who haven't been listening), the whole idea of the OMT is not to protect the Member-States but to protect the Euro. Even more, the OMT is best used as a threat rather than actual implementation. Market reaction to the threat was as predicted: pressure on the euro started to decline and soon the currency was much stronger than before. Yet, as many know, in this case, the threat is stronger than anything else.

You see, even if the ECJ approves OMT, it will do nothing to ensure that the crisis ends. The main function of the scheme is to purchase bonds in countries which are paying high interest rates (and are in bail-out agreement). As of lately, no country is paying especially high rates; even Greek bonds have shown significant signs of decrease. Thus, even if the scheme passes, no country will benefit.

Another idea, (one which I have to disgracefully admit that I thought was rather interesting before thinking it through) was a European Quantitative Easing. The problem here is how the markets that the ECB will purchase bonds from will be defined. It's easy in the US and the UK as there is just one market with sovereign bonds; what happens when you have 17 of them, each faced with its own issues? Clearly, QE is not the answer.

In order to find the correct answer, we have to make sure we are facing the right question, and the one in our case is how to stimulate demand. Forget of all the "competitiveness" and "supply liberalizations" which some think will cure everything. As stated before, supply does create its own demand but not all the time; and this time it's different. The problem is that the usual stimulants, i.e. government intervention (either in increasing demand or decreasing taxation), are constrained in the bailed-out countries, and many others by their debt-to-GDP ratios and fact that they are in a currency union. The other usual way, of increased bank lending, is again constrained by either the banks' inability to lend or the peoples' unwillingness to borrow.

Thus what is left one might add, if supply won't help and banks and governments are constrained? The magic word here is confidence and expectations. As recent research has shown, expectations matter more than we usually thought; the recovery from the 1929 Great Depression was most likely driven by a shift in expectations as Eggertson (2008) suggests. So what shifts expectations is the big question?

Simply put, it's the willingness of the governing authorities (whether those be politicians or policymakers) to stick to their agenda of reforms and promote the idea that inflation will increase in the future, or forward guidance in the central bank parlance (something that BoE's Mark Carney is famous about). The problem is that just saying so doesn't really change anything, you have to stick by what you claim and make efforts to keep them in line with peoples' expectations.

How to do that is rather simple: either the ECB should issue fresh money and channel them to the countries (most likely via the EIB) at a scale larger than ever before or boost bank lending in countries where banks are willing to lend (but are constrained) and people are willing to borrow, most likely by decreasing the ELA rate. I see no other solution to the current problems: either the banks are supported and they are allowed to lend, and more investment is brought forth directly from the EU or the shift in expectations will take much longer to manifest, just like it did in the 1930's. Trust me here, we do not want a repetition of history.

Austerity Strikes Back

The tale of the hard-working North vs the lazy South has been cited again and again during the past couple of years, mostly from Northern politicians who saw the on-going crisis as an opportunity to promote their own agendas. At the core of this "argument" was the self-assuring conviction that "we do not need them (the South), they need us". Through an array of measures mostly aimed at austerity in order for state financials to regain their vigor, the North is surprised at the increasing debt-to-GDP ratio in the short-run and is accusing some of the South for not pushing through enough reforms.

As has been explained before, when GDP goes down, debt has to decrease by much more in order for the debt-to-GDP ratio to remain constant. Yet, this will obviously not be the case as the economy contracts much faster than the GDP can be reduced. In addition, when policies are based on austerity, results are usually much harsher for citizens than when they are not. Even though many have failed to see it at the time of implementation, austerity measures in the periphery also affect the North. The simple rationale behind this is that the North was (until now) basically exporting while the South was largely importing goods; the heavy reliance on each other was more than evident as in 2010, no country in the Eurozone had less than a 57% share of intra-EU exports.

Yet, many continued to think that a heavy reliance on exports was a sign of a "vibrant economy" which would lead to higher wages and higher domestic demand. The brief answer is a big fat no. You see, the issue here is that heavy reliance on exports means heavy reliance on the well-being of your neighbours; if your neighbours are poor it means that they buy much less from you than if they were rich. Simply put, reliance on exports means that if they go down, they take you down with them. 

The issue is not new. Some of us have already discussed this in detail, and warned that this situation cannot go on forever. We were (unfortunately for the citizens of the North which are not to blame for the mistakes of their governments) correct. The latest data show something quite startling: Retail trade in December 2013, the month which generally signals the peak in consumer spending, has decreased by 1.6%, compared to November.

In monthly terms, Portugal and Spain were the leaders in the drop, although this did not come as a surprise. The "surprise" is that Germany, Austria, Belgium and Finland have also seen a sharp drop in retail spending. What is even more astonishing is that on a year-to-year basis,  Germany, Belgium and Finland lead the race in the drop. As if this wasn't enough bad news, the bank de-leveraging procedure which has been going on in the periphery appears to have started in the North as well. Germany, Austria and France saw total bank loans to non-financial corporation reduced by 1%, 1.1% and 1.5% respectively, and even if this is not large compared to what happened in the periphery (and Slovenia with the extraordinary 23.8%) it is indicative of the worsening situation in the region.

As a result of de-leveraging and the decrease in spending, inflation in the Eurozone has dropped to 0.7% on an annual basis. Even though just 4 out of 28 countries experience deflation, the rest are barely above 1%; only Austria is close to the ECB mandate of 2%.

North's problem can be reduced to two simple words: no demand. You see, as others also note as well, while banks are not currently in a large need for de-leveraging and are more than willing to lend their excess funds, they cannot do it in their domestic markets as people, in contrast to what most monetary authorities would suggest, are not willing to borrow even at near-zero rates. Less borrowing means less spending, or in economic terms less demand. This results in deflation, which in its turn ends up being a self-perpetuating situation (unless this is stopped as Irving Fisher noted in 1933). As consumption comprises more than 2/3's of GDP, output falls when consumption is reduced.

The situation has begun evolving in Finland where output decreased by 1.1% in November 2013 compared to the previous year, with the same thing occurring in October 2013. The 0.4% contribution to GDP growth led by net exports in the country in 2012, is unlikely to be repeated until demand in the South picks up. With the main forces of the decrease in the 2013 GDP being domestic demand and inventories (both driven by consumption and demand) the path appears to be same as Germany where net exports are expected to take growth down with them in 2014. Even though the country's trade balance has also fallen in December, the effect of local demand, which fell by 1.6% has taken its toll in factory orders in the last month of 2013.

As the gains from trade are not translated into higher domestic demand (either by credit or directly), these have to be tunneled somewhere: housing prices in Germany have soared by at least 25% (in some cases more than 35%) since 2008. The Lehman story has taught us that housing bubbles are not a good thing; actually Deutsche should remember its experience better. With the rest of the Eurozone decreasing imports and domestic demand where does the North expect to ship that 20% of GDP in intra-Eurozone exports and how is it going to sustain the level of GDP currently obtained if domestic demand is also shrinking?

What Secular Stagnation?

Note: this is probably the shortest post I've ever written

According to Larry Summers, secular stagnation is supposed to be reflected in the continuous decrease of bond yields since the early 1980's (the increase before can be explained in a simple way-inflation):

Yet, we usually forge to have a look at these:

Now remember where bank capital and most of the funds of the pension funds industry are (most times forced by legislation) invested: Bonds. I'd also like to remind some of the supply and demand premise in economics: when supply of funds increases then price increases and thus the yield decreases. And we are on a continuous search for safe assets to invest in. As the safest of all are government bonds (explained here) the increase in life expectancy has forced pension funds to invest more and more assets in the bond market (for a more detailed view of pension systems and population read this).

Concluding, I do not believe that stagnation can be inferred from bond yields. Declining returns just mean that the supply of funds for bonds has been stronger than demand and this is what's driving yields down. Now if that can affect the economy is a different story (one which I do not really trust to be honest since the US has been growing steadily since the 1980's), yet it does not indicate stagnation on its own. It just shows that when times are bad, people come up with a lot of explanations about what's at fault. But then again, I might be wrong and Summers could be right; time will tell.

Capping Banks' Rates

I've recently been in a discussion win which some academic proposed an interest rate cap for bank loans. When I asked whether he meant during the crisis or in general, his answer was "of course in general". His argument was that given the Modern Portfolio Theory which states that specific risk can be diversified away, when banks have a large amount of people as loan-takers then their individual risk will be diversified away and all you will be left with will be systematic risk which you can do nothing about. Thus, if the risk you have is just the latter, why should the banks charge different interest rates to lenders?

Although at first the idea might sound appealing to some, (it also abides with the "banks are bad people are good" motto), the problem with these kind of statements is that it shows a basic misunderstanding about how both the banking system and the risk-reward relationship actually work. To begin with, even in academia, higher risk is associated with higher reward. The basic reason is that you require a higher expected return to invest in something which will have a higher probability of costing you money. Simply put, if the risk of losing money is 10% one will surely ask for more potential money than if the risk is 5%. Thus, if the bank chooses to lend money to someone who has a 10% probability of defaulting then it makes sense to charge a higher rate than the one to be charged to someone whose probability of defaulting is just 5%.

"Sure" the academic would go on "but that risk can be diversified away". Well it depends what you really mean by that. Suppose that you have a stock market with stocks, between which you have to distribute your funds, having the following risk-return relationship:

Now suppose that someone told you that regardless of the risk, all stocks would have returns of exactly 6%. Where would you put your money into? Any reasonable investor would not be foolish enough to put his money in any stock which has a return of more than 6% in the above scenario because he knows that he will not be compensated for the risk he will assume. Thus, stocks 1,4,7,8,9 and 10 would have no-one to purchase them since their return would not be sufficient for the risk the investor assumes. In addition, stocks 2,5,6,11 and 12 would receive too much attention from investors since the risk they are posing is very little compared to what the capped return has become.

Let's put this is into banking perspective: instead of stocks, we have loans. Loans with higher expected return are those with higher interest rates, as for example business lending. If we cap the return banks can have at e.g. 6% then there will be loans which will not be issued, although in normal times the bank would most likely assume that risk and provide the funds (at a higher rate of course). What would this mean: essentially, those who have safe assets they can put as collateral, such as real estate or cash, would get funding while those who do not (for example 90% of the population) will not. This policy is not that terrible to the banks as they can adjust for these shortcomings; it is much more hazardous to the ordinary person who does not have collateral and cannot borrow at the low rates the bank will offer.

Why can't we force the bank to lend to the little guy you might inquire. Simply because the little guy bears more risk than the "big" guy. The bank has the discretion to reject any loan application it does not fit its risk-return profile. Forcing the bank to take up any loan while at the same time capping the rate is not a good idea; unless of course we really want another sub-prime lending crisis. 

In addition, high risk loans require higher capital requirements: business and consumer loans without any guarantees require much more than the 60% it is required for guaranteed ones. But the banks still give them. Not too many of course but they do. The thing is that if you take out all of the high risk loans you will be left out with no new Facebook, Google or Twitter. To get big you have to start small. And small without any lending is just tiny.

The reader would notice that my question was on the timing of the policy: if this is just a policy to be implemented as a short-term one I would have no problem against it. Why? Simply because just after a crisis banks are less willing to lend, and if they do then they lend to those who has a very low risk profile (i.e. the "big" guy). You don't have to take my word for what I described in the previous sentence; Hyman Minsky and Joseph Stiglitz said it much better, more than 30 years ago. Thus, as banks are less willing to give out funds, it would be much better to cap the rates during a crisis than after or before it for the simple reason that it would be much better for the existing loan-takers. It would take the burden off their shoulders, create an additional boost in consumption (or increase savings), thus moving us out of the recession. 

The short-term nature of this cannot be over-stated. If such policies are to be followed in the long-run then we would be in a situation where those who have will get more and those who haven't would get nothing. This is not only unfair it is also economically inefficient as, growth would also be threatened under such a scenario as no new high-risk projects would be assumed. Summing up: capping bank rates is good for the short-run, but only during a severe banking crisis; otherwise it does more destruction than benefit.

Why the Euro Hasn't Depreciated

Recently, The Economist had an article where it intended to explain why the Euro had not depreciated by as much as most believed, given the developments in Eurozone (Greek/Spanish/Irish bailouts, too much Italian debt, the Cyprus haircut, and so on). Without trying to come off as critical, the article did not really explain much about the Euro's endurance in the markets. In fact, the article did not really mention that in most cases not only the euro hasn't been depreciating, but appreciating for more than a year, with a slight fall in March 2013 (Cyprus haircut anyone?). Have a look at the following 2-year courses of the Euro compared to other currencies (Source: Yahoo!Finance):

USD/EUR

EUR/Canadian Dollar

EUR/Swiss Franc

EUR/Sterling Pound

In every one of the above charts the Euro has been appreciating from a low just before September 2012 (for what you see in the USD/EUR graph think of the reverse). Thus the question is what happened in September 2012? The answer is not something most would really believe: the Outright Monetary Transactions (OMT) scheme. This was presented by the ECB in early September 2012, even though the decision was announced in August. As you may recall, there have been many critics of the ECB's stance on the subject (amongst them was Yanis Varoufakis), claiming that the "bazooka" could never be used and the threat was not credible. 

Yet, as stated at the time both the timing and the actions were much more than the markets anticipated; this showed clearly that the ECB was willing to take some action on the subject. The point of the policy was that it was better that it was never used since there could be potential caveats (Paul De Grauwe and Yuemei Ji have an excellent post on the subject). Still, just affirming that the ECB was willing to act like a real Central Bank and prevent a meltdown did the trick. 

Although the OMT could account for the spike in markets, it wouldn't be sufficient for the longer trend. There are two additional reasons why the euro has been appreciating over time:

1. Increased trade surpluses Eurozone countries have been running for the past year

2. Very low inflation

The first reason is as obvious as it can get: when a country has massive exports then its currency appreciates. As the trade surplus has been on the rise, led by Germany and following by almost every other country in the EZ wishing to gain from exports or reduce their deficit, the Euro has been steadily increasing in value relative to other currencies.

The second reason is again obvious: the higher the inflation rate, the lower the deterioration of a currency's value. Thus, as inflation falls, as the next graph (originally posted on BritMouse's blog) shows, the value of the currency increases.

The trend is obvious as inflation has been steadily falling since 2012, but the interesting question here is why. The answer lies to something rather simple: bank loans. As banks have been deleveraging over the past year, the amount of money in the system is decreased, making inflation fall with it. The extend of this decrease in loans can be seen in the following graph (Hat Tip to the brilliant Frances Coppola for bringing it to my attention)

If the former graph is not descriptive enough, then the next, showing the M3 evolution over time in the Eurozone, will almost certainly be sufficient to convince most of those who are unwilling to believe that banks assist in inflation:

In essence, the Euro appreciation can be summarized in three simple points: commitment to "do what it takes" (raises trust and causes the original spike), a decrease in trade deficit and its conversion to trade surplus within a year (inflow of cash increases the value of the currency) and a fall in the inflation rate caused by bank deleveraging (makes the currency more valuable). Add to this the instability of several of the Eurozone's countrerparties (the UK and US for example) and the whole "mystery" of the appreciation is unveiled.

Is the Euro appreciation a good thing? Not really to be honest. First of all, the Eurozone needs inflation, for reasons explained in other posts. To get that, we need good banks. We do not have them at the moment. Thus, the whole appreciation issue masks the main problem the Eurozone is trying to hide at the moment, something which is even more important than the sovereign debt issues; the banking crisis. Why is it more important than sovereigns? Simply put, it's because sovereigns cannot issue money. Only the ECB can, and the banks are the only others which can increase that quantity.

Thus, their significance in a region which shares the same currency cannot be overstated. The banking system really requires reforms; yet, these should not come at the cost of growth. It makes no sense to start combing your hair before you can even stand on your feet.

The Banking System Part II: Repayments and NPL's

On a recent post, I gave an overview of how the banking system works and how the Central Bank assists in increasing bank liquidity when the latter wish to issue loans but do not have the liquidity necessary for that. The story presented in that article is what happens when the banks issue the loan and the customers use (i.e. spend) the money to purchase goods and services. As any good lender, the bank is not really giving the money to the public without expecting them back. Unfortunately for the bank, this promise to return the funds is not always kept as many borrowers default on their debts. In this post, I examine both scenarios (i.e. debt repayment and default on debt) and their implications in the economy as a whole.

1. Repayment

It would be much more suitable to examine the outcome of debt repayment by presenting a simple example. Let's assume that at time 0 the bank lends 100 units of currency a borrower, Mr A, who spends it in buying equipment for his shop. A year later, Mr A has to repay the loan with an added interest of 5 units of currency. For simplicity we will assume that there are no installments, just a large payment at year 1; in addition we assume that the bank only charges the interest at year 1. (In essence we are assuming the loan to have bond-like characteristics to make this analysis simpler. The same conclusions could also be reached even if our model was more realistic in its assumptions). Now, as stated before, when the bank issues the loan, it creates a simultaneous credit entry (the amount owed to the customer) and a debit entry (the amount owed by the customer) in its books, with each entry cancelling the other out. 

The amount of money in the economy also increases by 100 units when the loan is withdrawn and used by the customer. Yet, at withdrawal time, the bank does not owe the customer anything any more since the money was taken from it. This leaves the bank with just one debit entry: the loan granted to the customer.

At year 1, Mr A's investment paid off and he has enough money to repay his loan. He goes to the bank, hands them 105 units and bids them adieu. The bank accepts the money, accounts for it in its cash ledger and crosses off the debit entry assigned to Mr A.

Now, overall, if the money in the economy at time 0 had been X, granting the loan would have made it X+100. At time 1, if nothing else changed, the amount of money in the economy would become X+100-100-5=X-5. The startling discovery appears to be that when borrowers return money then overall money in the economy is reduced. Is this true? The answer is a bit more convoluted than expected. 

Money in the economy appears to be decreasing but this is not a permanent effect: in a real economy with millions of participants, just when any Mr A repays his loan, Mr B,C,D or E is eagerly waiting for his loan approval to use the money for buying a house, equipment or a fancy car. Thus, although the amount of loans in the economy appears to be reduced, this is just trivial and very short-lived: the reduction in money will be quickly countered with the increased liquidity the bank will have; given that the bank has not reached its regulatory capital maximum, the bank will now have 105 units available for lending which will mean that the money supply will again be increased shortly (provided of course that the bank finds enough good opportunities for lending).

An interesting question is what happens if, say 10% of borrowers decide to repay their loans at the same time: the answer is that a large decrease in the supply of money in the economy will occur, with all the known consequences of that (liquidity crises, deflation, etc). The only reason this has not happened is that people do not operate in such a fashion; it is much easier to spread payments over  5-6 years and pay a fixed amount every month than live on a shoestring and repay the loan in 2 years' time. Since life is generally unpredictable and people generally prefer stability it should not amaze us why people do not rush to the banks en masse to repay their loans.

2. Non-Performing Loans (Bad Debts)
Now suppose that Mr A could not find any suitable buyer for the goods he produced and thus he cannot repay his loan, making it a non-performing loan (NPL) for the bank (the usual definition is that of a loan whose payments are more than 90 days past due). This means that the bank will never receive its money back. What does the bank do then? Accounting-wise, the debit balance is transferred to the bad debts balance (for the purposes of this analysis bad debts will be the name this account has, although in practice the name may be different) which in its turn appears as a loss in the bank's financial statements.

Remember that when a bank issues a loan, it increases the money supply in the economy and it transfers liquidity to the customer when he or she withdraws it. In the case where the borrower cannot repay the bank, the money in the economy is unaltered (at the moment) while the bank's liquidity is reduced. A reduction in liquidity means that the bank will not be able to continue lending at the pace it previously could. While a non-performing loan here and there may not cause any issues, having too much can cause the bank to fail. When the bank does not receive its money back it means that it has no longer the liquidity it was supposed to have, which means that it can no longer keep lending or even worse, it will not be able to repay the Central Bank (or other corporations) for the liquidity it has provided. As a consequence, the bank will face liquidity issues and may be forced to default if the Central Bank does not allow it to borrow more.

Even though the total amount of money in the economy will appear not to change, it's rate of increase will be affected if banks face liquidity issues; bank credit will be decreased which means that money circulating in the economy will also be decreased (when we talk about money in the economy we usually use measures which include savings. Yet, savings are not usually used for transactions). Thus, less money available for transactions means that consumption will be reduced forcing the economy into a recession. Add to this fear resulting from reduced consumption and the recession and the velocity of money is further decreased, making a perfect crisis. This is what's currently happening in the South of Europe: banks face too many NPL's and cannot (and do not want as they fear for even more NPL's) lend as much as before, reducing the money available in the economy.

Now, let's suppose that Mr A put his house as collateral for the loan, promising to hand it over to the bank if he faced trouble. The best case scenario for the bank (and possibly for Mr A as well) would be for Mr A to sell his house to someone and repay the loan, keeping the rest to himself. Yet, if Mr A cannot do that, the bank will have to confiscate it. The problem here is that the bank does not really want the house unless it can sell it quickly and at a price high enough to cover the loan. A bank with too many hard assets confiscated (houses, equipment, etc) may face liquidity issues if it cannot sell them fast and at a good price; this is exactly what happened to the US housing market in 2007-2008 when banks found themselves with too much assets and too little liquidity.

From the above two simple conclusions can be extracted:
1. Repaying bank loans may appear to decrease money in the economy but since banks can reinvest the money received to other loans the decrease is not permanent. In fact, it may trigger a larger expansion of credit if the bank has not reached its regulatory maximum (in some countries, banks have actually lent money to their employees so they could purchase new equity issued thus increasing the regulatory maximum)
2. A large percentage of non-performing loans to total loans can seriously impair the bank's ability to lend. This will also affect the overall economy by decreasing the money available for transactions, thus reducing consumption and the velocity of money, resulting in a recession. If steps are not taken to boost bank liquidity an even harsher recession is most probably going to occur since people will reduce their spending even more, out of fear and uncertainty.

As already said, the banking system is not as complicated as many like to believe. By understanding simple accounting and macroeconomics and admitting that everything is connected, financial crises are easy to explain, and occasionally forecast (timing is of course extremely difficult). Although it is seldom mentioned, banks provide the lubricant for the economy machine; without them, the machine would clog and unclogging it would require much more effort than if we just kept the lubricant at a steady pace. Yet, the lubricant should never be too much: this could lead to spilling and creating more of a mess than keeping the wheels turning. It is just as important to keep the lubricant at reasonable levels as it is to ascertain that we do not run out of it.

The Banking System Made Simple

One of the most popular discussions on the web is banking. Numerous commentators have been commenting on how banks work or how we perceive that they work. These views are occasionally correct while they are also occasionally wrong. In addition, a relative confusion on how bank loans are created or why deposits are needed by the banks appears to exist. What follows are three simple examples intending to indicate how banking really works, how deposits and loans are created and how the Central Bank functions in a financial system.

In all examples, we assume (for simplicity) a closed economy where banks face a mandatory reserve requirement of 10% and a Tier 1 ratio which cannot fall under 10%. It is also assumed that the money needed in the economy for transactions is on average a fixed amount M (already existing in the economy) and all loans have a fixed risk weight of 40%. 

Note: all of the above assumptions can be altered with no change to the conclusions reached.

Example 1:One-Bank Economy

In this economy we have a bank which has in its balance sheet deposits of 100 units of currency with its equity being 10. In period 1 it decides, according to the regulations imposed above, to lend out 90 units. These units, we have just one bank in the economy will be deposited in the banks' accounts. A simple balance sheet would indicate the following:

Then, the bank would continue to operate under the same way until it reached the limit of 10%. This limit is nevertheless not the one imposed by the reserve requirements but by the Tier 1 needs. The reserve requirements would, under these assumptions, allow the amount of loans available in the economy to reach 1000 units had there not been for the Tier 1 ratio which essentially forces the bank to stop at 250 (for more details about the money multiplier see this). The "final" balance sheet would look like this:

Example 2: Two-Bank Economy

Now let's suppose that 2 banks exist in the economy, both having a 50% share of the market. Their equity values would be 5 each and their starting deposits would be 50.

In the first period of time, each bank will lend 45 units to the public. Each bank knows that it controls only 50% of the market thus it makes sense to expect 22.5 of those units to be deposited in its rival. Yet, the total amount of loans in the economy has not been altered even though the banks are now more and lending less individually. Total loans will still be 90 and they will be divided equally between each bank. Thus, each bank now knows that if the other bank lends as much as it will they will both get back in the form of deposits as much currency as they have provided as loans. In addition, the number of banks is irrelevant to the conclusion, as is their market share. If we had 10 or 200 banks in the economy total loans would still be 90 and the market share would have been the same after the lending as it was before. More still, the situation would not have been altered even if market shares were unequal. 

With some frictions, this is what most commonly occurs in real life: as banks do not have the same amount of loan applications or do not grant the same amount of loans in each period of time, market shares are continuously changing. Thus, although banks (usually) want to lend until their Tier 1 limit is reached, they cannot do this as easily (either because of lower demand or because applications do not match the perceived risk-reward profile needed) thus making market shares and loans growing at different paces in every bank. In addition, reputation makes a great difference; banks who were leading the market once are now mere followers as clients view others as better alternatives.

Example 3: Two-Bank Economy with a Central Bank Providing Liquidity

Assuming that the previous initial conditions hold, the situation should theoretically be the same. Yet, reality is different. Since the Central Bank can provide liquidity (what is called ELA in the Eurozone) for banking needs then it means that the banks can allocate their loans based on demand and not based on their liquidity constraints; what the Central Bank essentially does is eliminate the liquidity constraints in the short-run by lending banks. 

The situation would unfold as following: In period 1, banks face increased demand and decide that they should lend 60 units each instead of the 45 they are allowed by their liquidity constraints. This means that the Central Bank has agreed to lend an additional 21 units of currency (additional 10 to cover for the difference from 50 to 60 and another 11 so that they can have their regulatory minimum and not fact trouble in their day-to-day operations) to each bank with the banks promising to return it at a later date. The banks' balance sheets would now look like:

Notice that the Tier 1 ratio was 28% in Example 1's first period while it is 21% now. The reason is simple: more loans can be generated in less time using the Central Banks' available liquidity. 

A question is how the Central Bank will get its money back; after all this funding is nothing but a loan to the bank. Notice now that the bank who received the funding still has received 60 units of capital as deposits back. Now, according to the rules, the bank only has to maintain 11 units (10% of total deposits, i.e. 110) for liquidity. This means that it can afford to give the liquidity back to the Central Bank, hold the regulatory minimum for liquidity and still have 28 units (60-21-11) at hand which it will be able to lend in the next period.  That is if the bank does not get any more funding from the Central Bank to boost its loans.

As with example 2, in reality things are a little different. Banks not only borrow from the Central Bank but from each other as well, since their liquidity is changed every day (as stated before loan grants and demand is unequal between banks) and they may find themselves in need of some extra cash or have some extra liquidity which they prefer to lend out in order to get some interest instead of having it idle.

From the above examples we can derive the following conclusions:

• Deposits matter with regards to liquidity. Yet, they do not matter to the amount of loans to be given. As the balance sheets have indicated loans cancel out since their creation is a simultaneous creation of an asset and a liability. Thus, the bank has no limitation to the amount of loans it can create other than the regulatory capital requirements (e.g. Tier 1)
• The amount of money given by the Central Bank will be returned to it, yet its effect will be permanent. If the Central Bank agrees to give X units of currency to the banks then the money supply will be increased by more than X permanently even if banks return it to the Central Bank. This happens because that money is created by the banks and even if the extra liquidity is returned the amount of loans in the economy would have still been increased.
• The starting value of deposits is irrelevant. It does not matter whether initial deposits were 10 units of 10 million units. The amount of loans to be granted will be exactly equal to the amount allowed by the regulatory requirements and not by the initial state of deposits (obviously, deposits have to be greater than 0 for this to work since the bank cannot print money).
• The more cash at hand and the more government bonds banks purchase the more money supply they can create since both instruments are of zero risk weight and are thus excluded from the calculation.
• Increased regulatory requirements at a given amount of equity, means that less loans can be created, thus making money supply will in general be less; an increase in the regulatory requirement (e.g. from 10% to 11%) means that ceteris paribus less new loans will be created in the future. This situation is evident in the EU at the moment.
• The only way for money supply to be increased is for banks to raise more equity. If it is raised then more money can be created in the economy.

As the reader has seen through this analysis, the way banking works is not as complicated as we usually think it is. Nevertheless, understanding how the banking system works is paramount to the economy and has been an issue which had received much less attention than it should have. As stated above, the examples can be very easily extended to include more complexity; yet understanding the larger image can most of the times provide us with more knowledge than by narrowing our focus to the specifics of banking.

What Natural Interest Rate?

Most of the times, the articles that inspire me to write leave a positive impression on me. Other times, I just feel that a subject needs to be clarified or that an issue has not been addressed properly. There times though, like this one, where articles I read do not seem to understand that the issues they address are so theoretical and so convoluted that they have very little use (if any) to either consumers or firms. Although I like theory and believe that especially in macroeconomics many more (useful) conclusions may be reached from theory than empirical work (although not dismissing the latter), I share a strong resentment towards theory which cannot really focus on reality and presents the world on how it could potentially be or how its author believes it should be. Without further ado will let you know that the article which sparked this response is Miles Kimball's Natural Interest Rates: Clearing Away the Confusion

Perhaps, in some way, Kimball has cleared away the confusion on what he feels is the natural rate of interest. Although he mentions that low output levels lower the short-run interest rate (which is true) and the deeper the recession the lower interest rates should be to counter it (which is partially true), it appears that Monetarism got the best of him. Nobody would argue that interest rates play an important role in recessions, yet they are not a panacea: they can be employed to assist but they cannot do all the work on their own. For example, he states that monetary policy supposedly determines the equilibrium interest rates in the market. Yet, this not only does not really hold as Central Banks are most of the times retroactive in their responses; it is not until commercial bank rates rise that Central Banks raise theirs, meaning that unless we are to employ the previous period's policy rates in our calculations, we wouldn't factor the effect of monetary policy in estimating the short-run interest rate.

In addition, what is my greatest disagreement with not only Kimball but many economists is what is presented as the "natural" interest rate. This, is nothing but a number which might (or might not since we cannot see it) be true if we had no wage stickiness, price-stickiness or, in general, if them people (and yes I do mean all of us) did not distort the idea world economists are trying to build. (Ironically, economists do not act like the ideal people of the ideal world...)

The essence of the disagreement is that he believes (as many other economists do to be fair) that we could have both a medium-run and a short-run interest rate. What most economists fail to see is that we cannot distinguish one from the other even if they exist. In fact, they are so convoluted that we can only see the result of this interaction, without being able to see the original inputs. According to his definitions, we have an ultra short run, a short run and a medium run which would appear like this:

(Click to Enlarge)

As anyone may observe, in the medium run we would be experiencing the results of 4 distinct short run periods and 16 (!) ultra short run periods. This means that when we are about to measure the medium-run interest rate of an economy we have to take into account the short run as well, as it defines it. Suppose that we were at #1 and now we are almost at #16. According to the calculations made at #1, we would be witnessing the results of the medium-run interest rate which, according those calculations would be, say 2%. Now suppose that a recession or a boom occurs at #15, meaning that the interest rate would either be at 1% or at 3%. These effects are not due to neither fiscal policy nor technology shocks which Kimball understands as affecting the rate. They are, in fact, outcomes of the whole business cycle, models which lie behind the sticky-price, sticky-wage models.

The claim is that this medium-run "natural" interest rate is not a constant. If it was, then debunking their thinking would be too easy. Nevertheless, even saying that the medium run interest rate is not a constant actually indicates that we have some knowledge about what it would look like and we can re-calculate it with every new piece of information we get.

The reader may inquire why I am bothered with this. Yes, the medium-run interest rate is never what we calculate it to be, not just because of stickiness but because such a medium run does not exist. Still, this is just the tip of the iceberg. Kimball's argument is that investment, as he understands it, occurs when the benefit relative to amount spent is more than the real interest rate plus the depreciation rate and the obsolescence rate. What Kimball is trying to say (I think) is that basically the return on the investment made should be higher than the cost. Yet, this does not really depend on just the real rate, or to be specific the firm does not really care about the real rate. It does care about its return though. As long as the estimated return from the project is higher than the estimated rate it has to pay then the project is valuable. The firm cannot really know about the interest rate, more so about inflation, even at the Ultra Short-Run. It can only estimate them. Now, these estimates may actually affect both the rate as well as inflation, yet they are neither constant nor precise. They are mere estimates, which, considering Kimball's arguments should affect the medium run. Yet, there can be no medium-run estimate and neither can there be a long-run one. The reason is that they both require the economy to remain stable and stability is something the economy has never done.

It's not just that the economy needs to be stable to have the medium-run interest rate come out like we estimate it. It's that we have to magically transport ourselves from 2013 to 2025, with the state of the economy being exactly as it were 12 years ago, the same short run interest rate and have the exact same conditions. But... oh wait, if we had that, then we wouldn't experience the medium-run interest rate but the short-run one. This, makes the medium run a state which we cannot ever experience, even in theory.

Another issue with regards to the interest rate ups and downs is why the interest rate is lower in recessions and higher in booms. The reason that rates are lower in recessions is not because the real rate is not high enough or that depreciation rates are higher than in other periods (in fact depreciation should be the same in recessions and in booms). The reason is that the expected return in a recession is lower than the one in a boom. These are based on scenarios given the state of the economy at the time. When a wide enough problem has occurred in the economy which keeps demand down, it makes sense to lower estimates about perspective demand (whether firms are correct in estimating that is another question which is beyond the scope of this article). This means that the expected return of the project will be lower. Thus, the firms will say no to high interest rates and will continue to say no until these rates are lowered. The same logic can also be applied to consumers. If rates remain high because of Central Bank inaction, it could seriously harm investment expenditure in the country (or region).

Obviously corporate finance experts take the possible duration of a recession into consideration when they make their scenarios, but as usual when times are bad, people tend to err to the side of caution. In Kimball's words, the firms choose whether to "rent" capital (i.e. rent buildings, etc) and treats buying capital distinctly (separating it into two companies). Yet, renting capital would be the same as buying it if one considers that buying the capital means that they have to pay a depreciation expense which those who rent it do not incur. This is not really mentioned in the article, and at a point I just get the feeling that we employ perplexity for the sake of perplexity.

In addition, he mentions that people who work in corporate finance are more eager to buy when business is good than when business is bad. In all fairness, this all depends on how good or how bad things are. If sales are down 5% because of a recession, then we would be more willing to buy capital at a cheaper price than when sales are up 5% because of a boom and capital costs more. More so, he mentions that since capital does not change fast increases in wages and total worker hours push the rental rate up. This is true but it's not the whole story: the rate does go up but it is only because demand has already gone up and the firm is better off producing more than it did. Why? Well because the firm, seeing its products have more demand wishes to produce more in order to have more profits. Yet, this means that their estimates concerning new projects has been re-evaluated upwards, making them more eager to get money at just a bit higher rates than the current ones.

Thus, the workers who actually see this from the inside and understand that since their firm is expanding, money is more plentiful now and the outlook is going to be better in the future (in addition to seeing their employers earn much more than before) they demand higher nominal wages. This, in addition to the already higher demand, makes the interest rate rise. Now, from what we have already learned, this means that demand will be further encouraged with rates increasing even further.

Yet, in this analysis we have left out the role of the banks: when banks have more liquidity that they want, they are more willing to give out that money as loans. Thus, even though the demand for funds is increased during booms which makes the interest rate rise, the bank's willingness to supply funds is also increased (this means lowering the interest rates). The first is much more powerful than the latter though, for the simple reason that those who want to get money are usually more than the amount of money the bank is willing to lend, thus, the interest rate does not skyrocket unless in extreme situations (too much inflation for example). Another reason the rate does not skyrocket is that investment projects do not really skyrocket themselves. Although firms would have enjoyed it, they cannot earn a 35% annual return on a project (unless in very extreme and unsustainable cases) putting an upper limit to the rates; no firm would borrow at 15% when the most it can make is 12%.

Concluding, the main topic to be extracted from the article is that the defining powers of interest rates are firms, consumers and banks. The lower limit in a recession is imposed by the Central Bank (in the sense that it will not allow for the rate to fall below some point, i.e. not become negative) and in booms by the expected return on investments. There is no such thing as a "natural" rate of interest since it would necessarily mean that there are "unnatural" ones. There is only the prevailing interest rate of the economy. In addition, there is no "medium-run" interest rate, nor is there any way of actually experiencing such a rate; even if we lived in an ideal world filled with "homo economicuses".

Deposit Insurance Schemes: Proposals and Comments

A Bank Run on Northern Rock

Although Cyprus has managed not to set itself as a precedent for the rummaging of deposits less than €100,000, it has spurred an interesting discussion on whether deposit insurance is a good policy or not. Many have been arguing that the time has come when we no longer need such schemes and depositors are to be considered as investors. Others claim that without deposit insurance things would turn to the worse. Arguments on both sides of the story run as old as the history of the deposit insurance itself, which dates back to the early 19th century in the US, when the New York state fund was started; the second try of such insurance was in the early 20th century with the Oklahoma guarantee fund. Both programs were ceased when, in the words of the FDIC in 1953, "the great majority of state chartered banks became national banks". Nevertheless, both these issues were viewed positively by the FDIC, in several 1950's reports. (for a more detailed view of the history of deposit insurance, the Cato Institute provides an excellent review)


The main cause of failure of the first scheme was that very few had any knowledge of its existence at the time when it was functioning. As for the latter, it was the fact that it protected much more than it should have, leading banks to pursue aggressive policies which increased deposits dramatically (the report states that the largest bank in Oklahoma raised its deposits base eightfold in just a year). As "customary" when banks end up with too much liquidity in their hands, they lent it to real estate and oil speculators, including officers of the bank. This led to 121 state bank failures in 10 years, more than 12 times the number of national bank failures. Other deposit insurance schemes in the early 20th century, organized mainly by US states, experienced similar failures.

The current form of the deposit insurance scheme arose out of the desire to limit the probability of bank runs, similar to the ones experienced in the Great Depression, occurring. The FDIC was created by the banking act of 1933, and as of 2013 it protects deposits of up to $250,000 in 7181 institutions throughout the United States. In Europe, Directive 94/19/EC of 1994 required all Member-States to have a deposit guarantee scheme of at least 90% of the deposited amount, up to at least €20,000 per person. In 2008, this minimum was raised to €50,000 and in 2010 to €100,000 and 100% of the deposited amount up to that including a €50,000 for investments (HT to Frances Coppola for this).

The rationale behind insurance plans is that panics and bank closures are costly to the economy and subsequently to the citizens and the state. Thus, if the incentive to withdraw funds from a banking institution in trouble can be removed, the economy will function more smoothly without imposing any more strain to the financial system.

Nevertheless, both academics and non-academics are occasionally critical of the deposit insurance scheme. Charles Calomiris, in a 1990 paper, comments that deposit insurance relies heavily on "the full faith and credit of the federal government". In addition, current schemes in the US, in contrast to the earliest versions of insurance plans, do not restrict interest payments to depositors, require a trivial proportion of capital to deposits (compared to more than 10% in many older schemes) and banks can maintain higher leverage with the purpose of attracting more customers with higher interest rates. Others, promote the view that many bank runs are not pooling equilibria (i.e. everybody trying to pull their money from the banking system) but rather separating equilibria (i.e. trying to move their money from "bad" banks to "good" banks); their argument is that the Great Depression bank runs occurred mostly because people feared that the state would be the next to fail.

Non-academics also appear to believe that abolishing state insurance would mean that banks will have to be more careful about they way they operate, thus making the banking system more stable than before. Another case about depositors having to understand that deposits are investments and they should not feel that their money is safer in a bank than in an investment fund has been made and issues on whether just providing liquidity for banks facing troubles (like the now notorious ELA mechanism) would be better for safeguarding the financial system from frictions have been discussed, with many beginning to think that their savings are not as safe as they believed.

What most of the above arguments do not account for, is the inability of the "everyday" person to understand which bank is likely to face trouble and which is not. "Bad" banks and "good" banks are not easy to be distinguished, even if you are an economist. Annual reports are so lengthy and complicated (the Citigroup annual report is about 300 pages) that 99.9% of people cannot make sense of it. Even those who do understand what goes on in a bank just by reading its annual report, have much difficulty in providing forecasts. For example, how many forecasters foresaw that Lehman Brothers would collapse in 2008, other than David Einhorn? Even if they did, how many were willing to believe them and act upon their advice? (in fact Einhorn was severely criticized when he stated that Lehman would face trouble). Sometimes, not listening to predictions can be good as well: economists are known Cassandras (it was Paul Samuelson who said: economists correctly predicted 9 out of the last 5 recessions) and thus their advice is rarely valued. In addition, insolvency is difficult to distinguish from illiquidity when markets are frozen, even from the Central Bank point of view. If the Central Bank, with all its resources and expertise cannot be certain of the viability of a banking institution how can an investor, or even worse, a depositor, distinguish between which bank is good and which is bad?

Thus, we reach the conclusion that we can only understand when a bank is "bad" after the event has occurred. Then, imagine a person who has a deposit of €10,000 in a bad bank. If he knows that his money will be lost in the event of a bank failure, it would be better for him to withdraw it; and fast too, since others share the same feelings and the bank may be left without any hard money any moment soon. Thus, even though his incentive is just to remove the money from the "bad" bank, he has no incentive to deposit it elsewhere, since he does not really know (and to be fair no-one does) if the failure of one bank will lead to the failure of another. Although this may appear to be a separating equilibrium to theorists, a disincentive to deposit the funds he withdrew exists (and we haven't even considered psychological reasons of the "I do not trust banks anymore" kind). Thus, this is not just a shifting of funds from one institution to another: it is the exit of funds from the whole banking system, turning the separating equilibrium to a pooling one. If one takes into account the multiplier effects then the effects of the money exiting are even larger.

Providing liquidity to ailing banks if no deposit insurance scheme exists is the idea which could possibly support the system by in effect never allowing banks to fail. Nevertheless, this is exactly the kind of policy which provides the banks with the incentive to promote loans for speculative deals, regardless of the risk. If the banks know that they will face no trouble with liquidity, then why not invest in high risk, high return opportunities? Exactly like the Oklahoma state fund, history will be repeated, and even worse perpetuated, as this essentially guarantees that no bank will ever fail. Banks will become the most lucrative investments ever: high return, zero risk of defaulting. This means that if we currently have 3 banks then we are destined to live with those 3 banks forever, unless by some change of fate more banks enter the sector and these 3 are forced into miniscule market shares (which again, will not mean that they will fail; their market shares will just reduce). However, if an effective oligopoly is enforced in a market, what is stopping the participants from forming a cartel and keeping every possible competitor out? Nothing at all, especially if they know that they are too big to fail. What they are suggesting is in essence replacing an idea which distorts some incentives with one which distorts them even more.

A reasonable alternative which Frances Coppola proposed and I second, we have to distinguish between which bank is about to become a zombie and who will be healthy again once we throw some money at it. Taxpayers cannot support the banking sector's troubles, the central bank should. Essentially, in contrast to the former paragraph, this proposal means that banks should be allowed to fail. If so, then the trouble of bank runs, without deposit insurance becomes immediately higher. The recent example of Northern Rock has proven that although almost 80 years had passed since the Great Depression, people still rush to their banks when they believe that their money is in danger. Yet, although the run on physical money is rough on banks, wholesale runs are even harder. When individuals or corporations transfer funds in large quantities from the bank, it leaves the latter with liquidity problems. This, in the Eurozone is supported (most of the times) with ELA funding. Needless to say that the Laiki example exemplified what too much ELA can do to a country. Consequently, if terrified depositors make a run, the Central Bank will have to support the bank (if it does not want to wreck havoc in the markets and public) before even knowing whether the bank is going to be healthy even again.

What the careful reader should have realized by now is that the reason deposit insurance appears to work in the United States and not in Europe is exactly "the full faith and credit of the federal government". Let us not forget that financial crises, are "essentially failures of market confidence". When a Eurozone member guarantees that it will pay if a bank fails, it essentially makes a pledge to take a loan to repay what it will de jure owe to depositors. Nevertheless, the Eurozone country is constrained by it's existing debt burden, its current GDP and the amount of deposits it has to repay, while the US is basically unconstrained. Any amount of losses in the US system can be replenished by having the US Treasury create more money; just like it did with TARP in 2008. None of the Eurozone countries has this opportunity.

One of the most astonishing aspects of this discussion is that those who promote a revision in the deposit insurance scheme are scarce. The only person (to my knowledge) who had so far suggested that we do want a deposits insurance scheme but we should monitor the incentives it creates via regulation is Anat Adamati (at 21:30 of the interview). This crisis has been as much an outcome of distorted bankers' incentives as of lax and inefficient regulation; something which seems to be forgotten as we tend to blame the "bad bankers" for this, not remembering that those who monitor them should have done a better job.

It is, however, beyond doubt that the deposit insurance scheme in Europe needs revision, with the first issue being the definition of the Lender of Last Resort. As the Member States cannot issue any currency it is up to the EU (and subsequently the ECB) to assume that part, so that deposit insurance is not dependent of a state's ability to assume more debt. Continuing, the imposition of harsher regulations on the banks (e.g. more capital requirements, with 30-50% being the range more favoured by most) as well as a mandatory annual contribution relative to the size of their assets and a clear rule on which bank should be considered as insolvent would mean that the severity of crises would be lessened, with depositors not fearing for their money every time they see bad news about their bank.

Most importantly, what now appears to be largely forgotten by regulators and policymakers (and by most discussions on the subject as well) is that size matters: it takes much more money to compensate Deutsche Bank's (if and only if you allow it to fail that is) depositors than Laiki's. Thus, controlling for banks never reaching the too-big-to-fail level provides another, albeit indirect, source of stability for the deposit insurance scheme: if a small bank fails, the effects are minimal. If a large one does, then taxpayers will most likely have to pay the price of the wrongdoings.