The European solution to banking woes

Several European nations, most notably Germany, have introduced government guarantees on personal savings accounts at their banks. This approach to bailing out, bailing out the consumer, is completely different to the until-now ‘conventional’ approach of bailing out the institutions. There are very valid arguments both ways on this issue, so here’s how I see things.

The downside

The government guarantee approach adopted by Germany et al. might skew the allocation of capital in the market in favour of more risky investment decisions. Without government backing, every person with a savings account must first make an assessment of which bank or savings institution to deposit their money with. This decision will be based on numerous factors, with the security and stability of the bank being a major consideration. This in turn creates a market mechanism whereby savings tend to be deposited in institutions which are perceived to be safer. With full government backing this mechanism is completely destroyed. We are left with a system in which savers couldn’t care less about the security or stability of the bank in which they are depositing their funds because they know their savings are government backed. Presumably, this will in turn will lead to more money being deposited at dubious institutions which engage in more risky allocation of capital – malinvestment. So although the government backing approach is probably better for the consumer, which is good, it by no means bypasses the problem of moral hazard, which was my biggest criticism of the US bailout package.

The upside

The upside of this type of government intervention is that it virtually eliminates the possibility of bank runs. Ironically, a government backing of savings at banks reduces the possibility that the backing will actually be needed. When people know their money is guaranteed they have no reason to rush to the bank to withdraw their funds as soon as there is any loss of confidence. In other words, the positive feedback loop of loss of confidence is contained and not allowed to spread and engulf the entire banking sector and broader economy. So from this point of view the government backing can be seen as an investment into creating a positive market psychology that will rarely (if at all) actually require the investment of taxpayer dollars.

Conclusion

It’s important to remember that a government backing of bank deposits most of the time requires no input of taxpayer dollars whatsoever. It is only when there is a serious collapse of a bank that the intervention is actually called upon. I think the real questions are ‘what is the probability of a significant crash occurring that would require taxpayer dollars being spent?’, ‘to what extent will this kind of backing reduce the chance of a bank collapse occurring?’ and ‘to what extent will this kind of intervention distort the allocation of capital in the markets, leading to malinvestment?’. I don’t know the answer to any of these questions, but I’d welcome comments. On the whole though I tend to be inclined against deposit guarantees – they seem to be more of a populist measure than anything else. Having said that, like many issues in economics, I don’t think there is substantial data supporting either case, so it’s impossible to draw a conclusion based on empirical evidence.

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