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Befitting the populist climate, governments and regulators are falling over themselves to protect depositors. What could be fairer than shielding hard-earned nest eggs from the havoc wrought by evil bankers? As with all government meddling, however, this insurance has created distortions. Indeed, economists debate whether guaranteeing bank accounts may have contributed to the very instability it sought to counteract.
Deposits are part of a bank’s funding mix. As this debt is at least partially state-guaranteed, a bank’s cost of debt is artificially low. (Imagine the interest rate you would be demanding today if your life savings were not government-backed.) Cheap, sticky funds allow banks to get away with far more leverage than debt holders would normally accept.
A low cost of debt, in turn, drags down a bank’s overall cost of capital. This measure already paints a flattering picture as banks also understate their cost of equity, as investment company Knight Vinke has long argued. A depressed cost of capital means that some new projects, for example, are accepted that should not be. It also makes remuneration targets easier to hit.
What is the answer? Removing the government guarantee would be messy: as part of an efficient payment system deposits need to be fungible. Imagine having to assess the credit rating of the issuing bank as well as the individual when deciding whether to accept a cheque. The cleanest solution is for banks to reimburse taxpayers for the guarantee, roughly equivalent to the difference between the interest rate paid to depositors and the cost of unsecured debt in the market.
For banks with high deposit-to-loan ratios that will hurt. Good – higher funding costs will discourage leverage. Banking must be more stable. Deposit insurance – and that many banks were allowed to become too big to fail – was arguably part of the problem: governments must clear up the mess.
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