The German government announced that it will guarantee all private German bank deposits, covering both existing accounts and future ones. Details of the new scheme are unclear, but apparently it will replace the current protection scheme, which guarantees 90 percent of all bank deposits but only up to EUR20,000 per account.
This announcement follows commitments last week by the Irish and Greek governments also to guarantee deposits, with the Irish case also applying to wholesale and interbank deposits, as well as foreign currency (i.e. non-euro) deposits (including sterling deposits in the UK). The UK government last week announced that it will lift the ceiling for the deposit guarantee scheme from GBP35,000 to GBP50,000.
The Danish government announced Monday that it will guarantee all bank deposits in Denmark. In return for the government guarantee, banks have agreed to pay up to DKK 35bln (USD 6.5bln) in a liquidation fund that could take over distressed institutions, equal to 2% of GDP. Until now, deposits in Danish banks had been guaranteed up to DKK 300,000. The arrangement will continue until 30 September 2010, but can be extended if necessary. As part of the state guarantee deal, the banking industry “must complement the safety net by displaying a cautious approach and strengthening their balance sheets during the two year period. Therefore, the safety net will be combined with a ban on dividend payments and share repurchases by banks as well as new stock options for management. Expiring stock option programmes must not be renewed or extended”. The Agreement covers all banks in Denmark with a banking licence.
The Swedish government also has announced Monday that it is expanding its deposit guarantee for Swedish banks to SEK 500,000 from SEK 250,000 previously (was introduced in 1996) with immediate effect. Given the difficult situation, the government is prepared to go further if necessary, according to the press statement.
In practice, it now seems quite likely that most or all European governments will have to follow with complete guarantees for all or almost all private deposits, or by raising the ceiling of their deposit guarantee schemes to levels that are so high that the vast bulk of deposits (not just most depositors, but most deposits) are guaranteed, note Citigroup analysts. Now that several countries, including the biggest one, have taken this route, it will be hard for any other government to claim they do not want to follow or cannot afford to.
Deposit guarantee schemes are used quite often as a response to financial crisis. A recent IMF study of 42 banking crisis episodes found that blanket deposit guarantee schemes were introduced as part of crisis containment measures in roughly 30% of the cases, in order to reduce risks that the crisis is exacerbated by a flight of retail deposits.
To be sure, blanket deposit guarantee schemes have significant moral hazard issues if maintained long-term, because – unless backed up by tighter bank regulation — they provide equal protection for both cautious and more reckless lenders. However, while important, such long-term moral hazard issues are not the most pressing issues of the day right now. Moreover, such deposit guarantees measures create the risk that the state could have to bear a sizeable fiscal cost if major banks fail and there are not enough assets to cover deposits. However, such fiscal costs probably would be dwarfed by the fiscal and economic costs of the disruption that would occur if a major flight of retail deposits does occur. Moreover, for some governments (and this may be a factor for Germany) there could be a potential fiscal gain if the extension of the deposit guarantee leads domestic investors to repatriate deposits from offshore locations that previously offered scope for tax avoidance or tax minimisation.
Nevertheless, deposit guarantee schemes by themselves are no panacea. In particular, a recent IMF study on financial crises noted that “about half the countries experiencing a systemic banking crisis have an explicit deposit insurance scheme in place at the outbreak of the crisis.” Those crises happened even though a deposit guarantee scheme already was in place. The extension of deposit guarantee schemes may help reduce some risks of retail flight from banks, but by itself is unlikely to end the current financial and economic crisis. Most of the financial failures of recent weeks have reflected inability to access sufficient wholesale funding and inability to raise fresh capital, rather than a flight of retail deposits. Of course, a sizeable outflow of retail deposits from one or more banks would make the crisis worse, but there are plenty of issues of vulnerability even if that risk is reduced. The German scheme does not appear to extend to wholesale deposits, and hence a replication of this would not address the collapse of wholesale funding that is hitting so many financial institutions at present. But, of course, an extension of deposit guarantees to wholesale funding would for many countries greatly increase the potential fiscal cost. Nor do deposit guarantees provide fresh capital for the banking system.
The IMF recently argued that the key components of policy responses to financial crises are:
Crisis containment policies such as regulatory capital forbearance, emergency liquidity support, government deposit guarantees, and (an issue that is not really appropriate in Europe) suspension of convertibility of deposits.
And, crisis resolution policies, for example, recapitalizating financial institutions, using asset management companies (AMCs) to resolve distressed loans, offering debt forgiveness, and providing incentives for loan loss writeoffs.
The IMF stresses key principles: “Speed is of the essence to minimize the impact on the real economy”; “The adverse impact of financial system distress on the real economy may need to alleviated through measures that directly support firms and households”; “Steps should be taken to limit the costs and moral hazard implications of these policy responses”.
At present, European policy is edging towards such measures in a fairly ad hoc and erratic fashion. There may be plenty of detours and false starts in policy initiatives in coming days, weeks and months. The economic and financial crisis is far from over. In particular, most of the economic costs – in terms of lost output, lost jobs, business failures and house price declines – probably still lie ahead, conclude Citi analysts.
