On April 12, David Kotok penned a commentary about the runs and shifting of euro deposits from Greek banks to other euro zone banks where the questions about the ability to honor guarantees are less problematic. He pointed out the importance of credibility in honoring those guarantees, by contrasting depositor reactions in the UK and US with the destructive policies followed by Argentina as they abandoned their currency peg and devalued their currency. Another historical aspect of US deposit insurance policy is relevant to the current Greek problem, and that's our experience with state-sponsored deposit insurance funds.
The US has had a long history, going back into the early 19th century, with decentralized state-sponsored deposit insurance systems that were not backed by the federal government.1 This includes the New York safety fund system; funds in Vermont and Michigan that were established in the 1800s; and funds in Oklahoma, Kansas, Nebraska, Texas, Mississippi, South and North Dakota, Ohio, Maryland, and Rhode Island that were put in place in the early 1900s. All of these programs failed within a few years. Most recently this happened to the Maryland and Ohio deposit insurance systems in 1985 and Rhode Island in 1991. In each instance the schemes were unable, because of numerous critical design flaws, to meet their promised obligations when faced with unusual demands for funds when either a large financial institution failed or numerous smaller institutions simultaneously experienced difficulties.
First, the systems tended to be critically underfunded. Second, they were undiversified, either because the institutions were confined to a relatively small state and hence were vulnerable to regional business cycles or economic shocks, or because the failure of one or two large institutions was sufficient to bankrupt the funds. Third, they often had poorly designed governance systems, and this was particularly the case in the privately sponsored plans. Finally, when threatened with collapse, there was not the recognition that what provided credibility to the plan was not so much the size of the fund but the willingness of the sponsoring entity – in each case, the particular state legislature – to make good on the guarantees the fund offered.
Many of the same design flaws in these state-sponsored systems appear to be inherent in many of the systems that have been put in place in the European Monetary Union. Any fund whose insured base is not adequately diversified or that does not have the ability or willingness to use taxpayer resources, should fund resources be depleted, will not likely stand up to the costly failure of a few large banks. There are numerous European examples, both inside and outside the EU. These diversification issues are especially important in those EU countries with only one or two major institutions, where the failure of even one might endanger the entire fund. Smaller countries, in particular, with only a few relatively large institutions are more likely to experience funding problems than larger countries. At a minimum, this means that reliance upon private or quasi-private deposit insurance systems, which the EU directive permits, seems extremely risky. Moreover, even when a fund is private, this may not insulate taxpayers from fiscal responsibility, especially when the fund is jointly managed with both private and public officials from either the central bank, ministry of finance, or supervisory authority. Government involvement - either explicitly or implicitly - raises the perception of implied government backing, even without official recognition of that responsibility.
What most architects of deposit insurance schemes seem to miss is that it is nearly impossible to determine ex ante whether a fund is adequately funded. More importantly, what gives the fund credibility, especially when the financial problems in one institution threaten to spill over to others, is not the size of the fund per se but rather the willingness to make good on the guarantees, should the fund run out of resources. The differences in arrangements within the EU raise considerable questions about how responsibilities will be handled in the event that a fund gets in trouble. For example, some schemes are supposedly fully funded, some are only funded with ex post premiums or levies, some can make special assessments on their members over and above normal contributions, some can borrow from the public or central bank, and some funds, such as in Latvia, have an explicit provision committing the government to provide funds.
In the case of the Ohio Deposit Guarantee Fund, Professor Edward Kane points out that political waffling and legislative delay was a major problem. But delay and avoiding recognition of losses applies to federally sponsored programs as well, as the US experience surrounding the eventual collapse of the Federal Savings and Loan Insurance Corporation demonstrated. The protracted negotiations over the Greek situation reflect just such delay and avoidance on the part of the Greek government to confront realistically its fiscal situation, and this has cast doubt over its ability to meet its deposit insurance commitments. Reports now suggest that the Greek rescue package may involve up to 90 billion euros, which indicates that Greek financing needs may be greater than required to simply roll over its debt.
The circumstances surrounding the ODGF crisis also point to another problem related to the split of responsibilities for systemic risk between the member countries of the EU and the ECB. Specifically, the longer the delay in attempting to deal with the problem, the more likely it is that runs or systemic problems will develop that would convert what might be a problem in one institution into a problem for the deposit system itself. Individual member nations’ regulatory and legislative authorities, to the extent that they may be reluctant to impose costs on their own taxpayers, have incentives to delay and gamble that a broader authority will step in and assume the responsibilities for a crisis. In fact, this gamble has paid off - at least temporarily - as Germany and other countries have stepped up. The current EU problems illustrate what can happen when there is confusion over the role of the central bank - in this case the ECB, which appears to have been marginalized for the moment - and there is no centralized deposit insurance system or federal taxing authority.
In Ohio, the losses to the ODGF amounted to about $170 million, which was more than the state legislature was willing to appropriate to make good on the guarantees implicit in its state sponsorship. As a result, the FDIC stepped up and institutions were permitted to substitute FDIC insurance for that of the ODGF. Interestingly, research has also shown that depositors were able to distinguish between the quality of deposit insurance available to them, as Greek depositors are exhibiting today.
The Ohio episode illustrates two facts. First, it is the ability to tap into taxpayer resources as needed, rather then the size of the fund, that provides the credibility of the deposit insurance guarantee. The initial reluctance of the State of Ohio to live up to its commitment provides an interesting comparison to many of the countries currently in or entering the EU. Ohio’s state gross domestic product (GDP) in 1985 was $176 billion. This is larger than 8 of the original EU countries’ GDP, including: Austria, Belgium, Finland, Greece, Luxembourg, Netherlands, Portugal, and Spain. It is also larger than the real GDP of all the newly admitted countries to the EU.2 I would also point out that Ohio doesn't maintain an army, a navy, an air force or a diplomatic corp., all of which provide additional drains of available public resources.
It is not clear why countries with even smaller resources would be more willing than a relatively richer state like Ohio to honor their deposit insurance liabilities, especially if payments were to be made to resident depositors in other, larger EU countries. The temptation on the part of poorer counties and their politicians may be to gamble, in the hope that they will be bailed out by the ECB should a major crisis arise. A chief difference, of course, between the resolution of the ODGF crisis and a potential deposit insurance crisis in the EU is that there is no federal deposit insurance fund in the EU to which losses could be shifted.
From an investor's perspective, how things are playing out in Greece should be no surprise. The unfolding of the saga and the pending problems in other EU countries show that the recovery has a long way to go, and illustrates why we at Cumberland selectively have shied away from countries like Greece in favor of others like Germany and the Netherlands.
1This commentary draws extensively upon an appendix in a paper I coauthored with Professor George G. Kaufman entitled "Cross Border Banking: Challenges for Deposit Insurance and Financial Stability in the European Union," which was presented at the Third Annual DG ECFIN Research Conference, "Adjustment Under Monetary Unions: Financial Markets Issues," September 7 & 8, 2006, Brussels, Belgium, sponsored by the European Commission Directorate General Economic and Financial Affairs, Economic Studies and Research.
2As of 2008 the GDP of Ohio was still greater than that of Greece.