LONDON Bailing-in depositors with banks in Cyprus is a serious policy error that will destabilize the European banking system and threatens to accelerate bank runs in future.
There is a good reason deposits have been the most protected form of bank liabilities. It has nothing to do with fairness.
Deposit protection is the most successful banking policy enacted in the last 60 years.
It has banished the runs that plagued banks and savings institutions in the early 20th century, leading to the suspension of thousands of banks a year in the early 1930s, and which erupted again briefly in the mid-1980s, felling hundreds of savings and loans in the United States.
If European policymakers need reminding about the terrible dynamics of a bank run they need only consult Robert Bruner and Sean Carr's monograph about "The Panic of 1907", or "Integrity, Fairness and Resolve", the history of the savings and loan crisis published by the Federal Reserve Bank of Kansas City.
"Depositors knew all too well what to do," in the savings and loan crisis, the Kansas Fed wrote. "They gathered up their lawn chairs, thermos bottles and portable radios and lined up outside the banks as if they were embarking on a familiar American outing."
"In a sense they were. Only two months ago, depositors across the U.S. witnessed scenes right out of the Great Depression during a panic that temporarily shutdown Ohio's privately insured thrifts," according to the Fed, quoting from contemporary news reports.
Bank runs are rational when depositors fear they may not be able to get all their money back, or face lengthy delays. But what is individually rational, is collective madness.
Deposit protection, either through formal insurance schemes or the informal preference given to depositors ahead of other bank creditors, aimed to prevent runs from ever occurring again, by convincing depositors that they would always be able to get their money back.
Like other financial policies, deposit protection is all about confidence. The more that investors trust their deposits are safe, the less likely it is deposit insurance or other guarantees will need to pay out.
For 60 years, deposit protection has brought a high degree of stability to banking systems across the United States, the European Union and the other advanced economies. The recurrent banking and financial crises of the 19th and early 20th centuries have become a distant memory.
With one ill-thought-out deal, the EU threatens to undo all that progress.
PRE-EMPTING THE BAIL-IN
EU officials have been quick to stress that the circumstances surrounding the banks in Cyprus are unique. Haircuts are not being considered as part of the workout for troubled financial institutions in other member states.
There has also been plenty of off-the-record briefing that many of the deposits are from wealthy Russians and some may be the proceeds of tax evasion, crime and money laundering.
The first claim is not credible; the second is not relevant.
The EU cannot avoid setting a precedent. The next time rumors start to circulate about trouble at a financial institution in a member state, depositors must reckon with the risk they too will face a deposit levy as part of a workout. The rational response is to pull deposits out as fast as possible.
Deposit levies sharpen the incentives for a self-fulfilling bank run. They threaten to make each future crisis worse.
In September 2007, friends with large deposits in Britain's Northern Rock bank, which was subsequently nationalized, approached me for advice about whether to withdraw them as concerns about the institution grew.
At the time, the British Bankers Association was assuring customers their deposits were safe, though that was only true up to a point: the government guarantee scheme covered 100 percent of losses on the first 2,000 pounds but only 90 percent on the next 33,000 pounds, and nothing above that level.
"Northern Rock is a safe and sound bank and there is absolutely no reason for either mortgage customers or savers to worry," the BBA said in a statement on September 14, 2007.
By contrast, my advice was to withdraw the money. Funds could always be put back on deposit if the institution survived. Even if the risk of failure was small, there could be lengthy delays in deposit protection paying out.
There was no upside from leaving funds with the institution - no uplift in interest payments or tangible thanks for loyalty. Only downside if the bank failed.
If wholesale investors with sophisticated credit departments were reducing their exposure, there was no benefit for retail investors in staying put.
Policymakers understand this. At the height of the financial crisis in 2008 and 2009, deposit insurance systems across the EU were made more generous, covering more deposits, in a bid to prevent a rash of panicked withdrawals and banking failures spreading across the EU and U.S. banking systems.
The Cyprus depositor bail-in sends the opposite signal. Following the Cyprus example, the only responsible advice to depositors concerned about the liquidity and solvency of other EU financial institutions must be to withdraw their funds first and wait to see if the institution survives.
In future, depositors will have an incentive not just to run for the exits ahead of possible suspension, but also to escape any possible levy. No realistic interest rate can offset probable losses from suspension, failure or being levied, all of which are low probability but high consequence events.
Is this really what EU officials want?
ONCE LEVIED, TWICE SHY
There have been suggestions that because many of the Cyprus deposits are owed to non-EU nationals and some may have dubious origins, that justifies making an exception to deposit protection.
The argument is spurious. If there are concerns about the origin of the money, that is a matter which should have been dealt with through tougher regulation before the crisis erupted. It points to weaknesses in bank supervision at both national and EU levels. It is not a justification for imposing a levy now. It is certainly not an argument for imposing a indiscriminate levy on all depositors whatever the origin of their money.
Some officials and commentators have suggested the levy will be "progressive" if it falls mostly on those with big deposits.
Put aside that the level at which large deposits are defined is just 100,000 euros. The main problem is that Cyprus needs these depositors to leave the rest of their funds with its banks if the crisis is not to get worse.
Economists will argue depositors should treat the levy as a one-off sunk loss. Banks will be safer after the bailout and levy than before. So depositors should leave their remaining funds.
But the harsh terms of the bailout reveal something about the policy preferences of EU officials and their relative hostility to large depositors, especially those from overseas.
There must be a risk overseas investors with large deposits try to extract the remainder of their savings. There is only upside in withdrawing the deposits. The risk is that once the banks re-open, the levy will intensify the run, making it worse not better.
Even if the situation in Cyprus can be stabilized, the bail-in sets a terrible precedent.
Next time an EU financial institution runs into serious trouble, EU policymakers will assure depositors no haircut is being contemplated. But who will believe them?
"Fairness, Integrity and Resolve: Lessons from Bill Taylor and the Last Financial Crisis", 2010
House of Commons Treasury Select Committee Fifth Report, 2008
(John Kemp is a Reuters market analyst. The views expressed are his own)
(Editing by Catherine Evans)