Monday, October 6, 2008

What happens if everyone gets deposit insurance -Beggar-thy-guarantee

One of the classic tools in debate is to take a argument to the illogical extreme to determine what are the implications of an action. We are seeing absurd extremes with respect to the the deposit insurance issue in Europe. Ireland provided 100% deposit protection last week, and now Germany announced guarantees of savings for all private bank accounts. So now there s no difference between holding a government security and a bank deposit.The implications are huge.

Ireland guaranteed $567 billion in liabilities including covered bonds, senior debt and subordinate debt. Germany will guarantee about $775 billion in deposits. There is a complete blurring of private and government savings alternatives. There blanket of being a risk free asset is now taken on by banks. But if every asset is a risk free asset then nothing is a risk free asset.

Details are still unclear, but let's review a simple scenario. Money will move across borders to take advantage of the guarantee. if you are in Europe, why would you hold your money in any bank except those of Germany where you have the guarantee. You should take your money out of Italy or Spain, which are still denominated in Euros, and place the money in a German bank. Beggar-thy-guarantee. so everyone will have to provide a similar guarantee across Europe which means that you still have to determine the risk of the country because all countries do not have the same ability to guarantee deposits.

Who cares about collateral now that deposits are guaranteed. Depositors do not have to worry about the safety and soundness of the bank. Depositors have to worry about the safety and soundness of the government. This will have strong implications on the European union. Should guarantees by a government extend to all depositors, even citizens of another country?

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