There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

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No, not that kind of haircut.

I’m talking about the kind of haircut where depositors lose a portion of their money. This can destroy confidence in a fractional reserve banking system, as depositors in other banks and other countries fear that they too might be forced to take a haircut, leading to mass withdrawals, leading to illiquidity. And — as part of an E.U. bailout of the Cypriot financial system this just happened in Cyprus:

Eurozone finance ministers have agreed a 10bn-euro (£8.7bn) bailout package for Cyprus to save the country from bankruptcy.

The deal was reached after talks in Brussels between the ministers and the International Monetary Fund (IMF).

In return, Cyprus is being asked to trim its deficit, shrink its banking sector and increase taxes.

For the first time in a eurozone bailout, bank depositors are facing a levy on their savings.

This attack on depositors will have clear implications for depositors and banks in other bailout-prone areas of the Eurozone — Spain, Italy, Greece, Portugal. If the EU is prepared to impose haircuts of up to 10% on depositors in Cyprus as part of a bailout package, which countries’ depositors will be forced to take a haircut next? Mattress-stuffing Cypriots will be 10% better-off than their compatriots with confidence in the banking system. Even if only 10% or 20% of bank customers in Spain choose to withdraw their funds, that has the potential to cause serious liquidity problems.

Whether or not this actually happens is another question — although with unemployment running high throughout the Eurozone, those with savings may be particularly wary of losing them. This decision — no matter how many times Draghi and Merkel and Barroso reassure the crowds — makes bank runs throughout the Eurozone much more likely as savers seek to avoid the possibility of a haircut by moving to cash or tangible assets.

And this madness was totally avoidable.

53 thoughts on “There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

  1. It’s important not to throw a baby out with bathwater here.

    Full reserve banking is a system under which depositors CAN TAKE a hair cut. To be more exact, depositors have a choice between their money being 100% safe, in which case it is not invested at all: it could just be deposited at the central bank. So there is not taxpayer exposure there, i.e. no bank subsidies.

    Secondly, depositors can elect to have their money loaned on or invested. Under Laurence Kotlikoff’s full reserve system, such depositors put their money into unit trusts (mutual funds in the US). Those funds then lend to mortgagors, business or whatever. But if those funds go belly up, the investor/depositors take a hair cut, or lose everything, just as they do if an existing unit trust loses everything (which has never happened far as I know).

    In the latter case again, there is no taxpayer exposure and no bank subsidy. In fact banks as such cannot go bust. Or put another way, banks as we currently know them cease to exist.

    The above would of course result in less lending, i.e. there’d be a deflationary effect. But that’s easily dealt with by having government / central bank create and spend new money into the economy.

    • Key point is this bail out reneges on the govt promise of deposit insurance. Sure, if you had more money in the bank than the insurance cover you knew you were taking a risk. Now we find that the deposit insurance is worthless and you were taking a risk anyway. Bank runs around the world then? I mean all deposit insurance schemes in Europe are worthless if this goes through. I suggest bank note printers and safe manufacturers will be booming industries again.

    • Where exactly is the ****ing madness? The banking industry is split into two halves. First there’s the ultra safe half which cannot fail. As to the half that lends or invests, and assuming it has shareholders and bond holders, the latter two get wiped out first. While depositors get wiped out in the event of the bank’s assets turning out to be totally worthless, which almost never happens.

      Alternatively, and assuming the Laurence Kotlikoff model, depositors are effectively shareholders. And if the bank fails, those shareholder/depositors lose out.

      In fact depositors at British building societies already are effectively shareholders, as pointed out by Mervy King. See 9.40 minutes into this video:

      Can’t see the problem.

        • Why so? 100% reserve is by definition a system where the only money is central bank money: i.e. commercial banks cannot “lend money into existence” as the saying goes. It is not a system that guarantees depositors won’t suffer a hair cut.

          Quite the reverse. If I buy bonds in corporation X and it fails, then I lose out. In contrast, under our existing daft banking system, if I lend to a bank and the bank lends to corporation X and it goes belly up, the taxpayer rescues me. Where is the logic there? And where is the logic in taxpayers underpinning or subsidising entities, i.e. banks, that are supposed to be commercially viable?

          Under the existing system, if I deposit £X at a bank, and the bank lends it on, then both the borrower and I then have £X: £X has been turned into £2X. The bank has created money.

          In contrast, under full reserve, I’d get a security that was definitely not money on any normal definition of the word. E.g. under Kotlikoff’s system I’d get mutual fund units. In short, the fact of banning private money creation automatically stops people who want the benefits of being a shareholder suddenly claiming to be little old ladies whose savings have disappeared and pleading for taxpayer assistance when it all goes wrong.

        • If I buy bonds in corporation X and it fails, then I lose out. In contrast, under our existing daft banking system, if I lend to a bank and the bank lends to corporation X and it goes belly up, the taxpayer rescues me. Where is the logic there? And where is the logic in taxpayers underpinning or subsidising entities, i.e. banks, that are supposed to be commercially viable?

          You’re right, the status quo is totally screwed up.

          My understanding of full-reserve is that there are sufficient funds or securities held to guarantee that banks do not become illiquid in case of a run. If a bank is holding government-backed securities (or cash, or gold, or MFUs, etc) equal to deposits, then depositors do not take a haircut in case of blowup.

      • I think Full Reserve Banking under the scenarios you have mentioned has merit. I think IMF mandated increased bank fees as an insurance (Bailout system) is akin to a hair cut. It just sounds less menacing and bank running to the average person. Either way it shores up bank capital losses.

        • Reply to Aziz’s comment Mar 16, 2013 @ 18:40:26:

          Your description of full reserve doesn’t quite tie up with full reserve as advocated by Laurence Kotlikoff or the slightly different version advocated by Positive Money, the New Economics Foundation and Prof. Richard Werner.

          Under both versions, the money lodged by depositors who want 100% safety is backed by monetary base or government debt. (I prefer the former, as even government debt is not 100% safe – think Greece.)

          As to money that depositors want loaned on or invested, they get a share in those investments (under Kotlikoff’s system). And the value of those shares can rise or fall. But if they fall, that’s not a huge problem: there is no reason for a run on the bank to ensue. What happens is little different to a stock market set back. As Mervyn King put it, “we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis”.

          Positive Money’s system is a bit different. Depositors wanting their money loaned on have to lodge their money for several months, plus they have to accept the possibility of a hair cut. The interest they get varies with the time for which they lodge their money and the size of haircut they are prepared to accept.

  2. I’m pretty hacked off here as I have money in Cyprus as there is a banking deposit insurance scheme. The instruction to return funds back to the UK will be issued Monday (less haircut obviously). The problem as has been noted is that this screwing over of depositors ahead of shareholders and bondholders will serious de-stabilize banking – I think we are going to see some massive bank runs. Fortunately I have been stacking physical for some years now…

    • Sorry to hear it. Some are saying this is the Lehman 2 event. Probably not that bad, but a serious mistake by Cypriot government, IMF and EU. Very dangerous. Stacking physical a smart move.

      • BTW. I worked at the Bank of Cyprus in Australia. I got a 24k gold plated lapel Pin “Bank of Cyprus with wreath” It is probably worth more than the bank LOL

    • Sorry to hear. If they issue a decree to come for your gold, what do you do? Sew it into your jacket?

      History is repeating. The system and human response never changes.

  3. John: Please compare inflation “haircuts” to those from banks/central banks.

    And — please excuse any implication of impertinence — it’s good to find you back in economics from earth pseudoscience.

      • 1/ Well the key difference between inflation haircuts and nominal haircuts is that the effect is direct and indisputable. With money supply increases, the effect on purchasing power as a result of money supply increase is delayed and indirect. If one is smart with their money, they can avoid the long-term negative effects to their purchasing power of a money supply increase. It is impossible to avoid the effect of a nominal haircut on your money held in a bank. Unless, of course, your money is somewhere other than a bank, like inside a mattress. Which is why the possibility of bank runs has greatly increased.

        2/ Cyprus agreed to it, but apparently Germany insisted either Cyprus’ depositors took the haircut, or they would kick Cyprus out of the Euro.

        • Once they abolish physical cash, and relegate people’s life savings to electronic bank books, this type of haircut would be so much easier. All banks would be participants. No where to bank run muhahwhahahah!

        • Woops…. We made a mistake…. the money you deposited was actually over valued by 10%. Retroactive inflation….. A sane person would take whats left and join the mattress stuffers.

        • Neither Germans nor other country in EU can kicked out of Eurozone any EU member country as there are no such provisions in EU constitution.

  4. Via the BBC link above:

    “People with less than 100,000 euros in Cypriot bank accounts will have to pay a one-time tax of 6.75%, while those with more will have to pay 9.9%. It is expected to raise 5.8bn euros in additional revenue.”

    So if I am a Russian Mobster, with 1 Billion Euros in a Cypriot bank, I just lost 100 million. No chance of withdrawing earlier, as the Cypriot authorities have taken measures to ensure money can’t be removed to avoid the tax?

    Whoever signed off on this better be careful.

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  8. This is insane! Wow – l couldn’t have thought of a better way to scare the masses and undermine the banking system. Maybe this is one reason that bluechips are rising.

  9. BitCoins have no value!!!
    You can smoke cigarettes, you can grow food on land you can make jewelry out of gold and silver, you can pay taxes with fiat.
    Bitcoins are worthless, the ultimate expression of wealth destruction.

  10. And this madness was totally avoidable.

    I would like to better understand these things, but banking is not my forte. Could you explain what you believe would have been a better response, perhaps in an ideal world but especially in the political reality that is the EU. (I mean, I suppose it is possible that there is no viable way out of the mess at this point, and it’s just a matter of how long and how bad, but saying this was avoidable makes me think you see a better way, at least for this particular Bailout #5.

    • Banking is a state-sanctioned method of abstracting labor-value into money so that those who control money can steal it from everybody else.

      • Ok, but who’s doing the bailing? It sounds like Cyprus can’t afford to bail out its own banks, so it was either 90% or 0%. I was under the impression that the “others” (Germany? EU? IMF?) are becoming increasingly resistant to continuing to bail out the failures. But it also sounds like this haircut only reduces the amount of bailout coming from the others? So is your position that another full bailout would have been better than a cheaper partial bailout due to the huge precedent and the destabilizing repercussions being worse than the continuing precedent of full bailouts? (Forgive me if I’m mixing up some key players and concepts here)

        • I have an old book. The history of the National Bank of Australasia (Published 50’s). In the past bank runs were common and people lost money. It was a fact of life. High interest equals your manager is gambling with your money.

          I think this was the fairest method. Everybody took a cut, instead of connected insiders. But I would like to see a national inquiry into large withdrawals over the past few months.

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  12. European Union is experimenting with Cyprus. If Cyprus parliament votes in favour of the deposits cut then be sure that this experiment will become a fact and then it will be imposed in other countries in EU

    • Europeans in periphery not looking to become subjects of similar experiments, hence bank runs become much, much likelier. Very, very hard to reassure people.

    • I agree. I think all depositors will feel the burden using a progressive taxation system.

      Its either the 99-1% or the 0.99-0% feeling the pain.

      If you are not in the club, your are a peasant.

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