Tuesday, October 21, 2008

Are we in a Deposit Guarantee Arms Race?


It all began with Ireland at the beginning of this month. Greece followed soon afterward. Now all nations are scrambling to follow suit. To not undertake a similar move would be tantamount to tilting the playing field in favour of those that do.

I am talking about providing absolute government guarantee on all bank deposits.

Now, in efforts to stem their biggest depositors from scrambling towards the country that guarantees all its deposits, all nations are forced to follow suit with their own versions of a deposit guarantee. In these times of crises and capitulating investor confidence, total and all-out guarantee is the name of the game. Today’s risk-averse depositors demand nothing less. Greece had announced that deposits "in all banks that operate in Greece" would be "absolutely guaranteed".

Are you a government who can’t afford, or refuse to guarantee all your local banks’ deposits, on grounds of principle? Then be prepared for the adverse consequence of losing them. Refusing to keep up in the new deposit guarantee arms race is a sure-fire way to cause a quiet bank run on your banking system. And that is the sure-fire way of ensuring your banks end up needing your government’s intervention.

So nations the world over are now figuring out how to recapitalize their Deposit Guarantee Institutions, and to legislate their own version of TARP. After all, TARP has had the unintended consequence of providing large depositors with a risk arbitrage – to take their deposits out of locales with low levels of deposit insurance, and into those that guarantee the whole lot.

This is an unprecedented escalation of economic warfare, where the government stands as the bazooka that enables its infantry banking institutions to decimate the competing banking army. In this new economic environment, guess who wins in the end? That’s right, the army that has the biggest bazooka.

Banks have since their inception battled to get the biggest and most credit-worthy businesses and firms as their clients. Traditionally, the richest individuals and the bluest of the blue chips have established their relationships with the largest, most stable banks. Now that the credit crisis has unravelled the belief that there are still stable banks out there, the implicit backing of the government has become the de facto gold standard of choosing where to bank.

But hey, if you’re a businessman, you’ve work hard to maintain your income in this difficult environment. The last thing you need is another matter to worry about, that the place where you maintain your checking accounts, receivables accounts, salary accounts, and savings accounts just might go under. So if you happen to have a subsidiary in Greece, then all is well.

Similar arbitrage opportunities could be exploited by enterprising nations in other regions of the world. This could prove to be a golden opportunity to attract capital at low cost. Who would have thought we’d get to a point where a competitive advantage of a country would include its government’s capability and willingness to step in and be the guarantor of last resort.

Of course, not all countries are made equal. Some will have a more solid fiscal footing than others. Some will have a deeper currency reserve than others. Some will have a more stable banks, and much bigger local firms. As a result, not everyone will provide for absolute guarantee.

But then again, which country really has the financial footing to guarantee all of its deposits? The bigger the deposit base, the bigger the potential liability. At the end of the day, what we have ended up doing is taking the derivative risk management game up a notch, to the level of national governments.

Investors and bankers in the last decade thought they had prudently and magically rid themselves of credit and default risks by entering into various credit default swaps, buying default insurance, and entering into ever more elaborate cross-party guarantee schemes. At the end of the day, these risk management schemes unraveled in a black swan event where the biggest, most inter-related counter-parties suddenly failed.

Could another black swan event happen to unravel the financial thin ice of absolute government deposit guarantees? If none is obvious in forthcoming, bad times could be ahead for those governments that do without it.

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