Why Europe Won't Let Banks Fail

Dan Mitchell describes three possible government responses to an impending bank failure:

  1. In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.
  2. In a system with government-imposed deposit insurance, taxpayers are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.
  3. And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

I would argue that in fact Cyprus has gone off the board and chosen a fourth option:  In addition to bailing out shareholder and bondholders with taxpayer money, it will protect them  by giving depositors a haircut as well.

The Cyprus solution is so disturbing because, hearkening back to Obama's auto bailout, it completely upends seniority and distribution of risk on a company balance sheet.  Whereas depositors should be the most senior creditors and equity holders the least (so that equity holders take the first loss and depositors take the last), Cyprus has completely reversed this.

One reason that should never be discounted for such behavior is cronyism.  In the US auto industry, for example, Steven Rattner and President Obama engineered a screwing of secured creditors in favor of the UAW, which directly supported Obama's election. In Cyprus, I have no doubt that the large banks have deep tendrils into the ruling government.

But it is doubtful that the Cyprus banks have strong influence over, say, Germany, and that is where the bailout and its terms originate.  So why is Germany bailing out Cyprus bank owners?  Well, there are two reasons, at least.

First, they are worried about a chain reaction that might hurt Germany's banks, which most definitely do have influence over German and EU policy.  There is cronyism here, but perhaps once removed.

But even if you were to entirely remove cronyism, Germany and the EU have a second problem:  They absolutely rely on the banks to consume their new government debt and continue to finance their deficit spending.  Far more than in the US, the EU countries rely on their major banks continuing to leverage up their balance sheets to buy more government debt.  The implicit deal here is:  You banks expand your balance sheets and buy our debt, and we will shelter you and prevent external shocks from toppling you in your increasingly precarious, over-leveraged position.

Update:  Apparently, there is very little equity and bondholder debt on the balance sheets -- its depositor money or nothing.  My thoughts:  First, the equity and bondholders better be wiped out.  If not, this is a travesty.  Two, the bank management should be gone -- it is as bad or worse to bail out to protect salaried manager jobs as to protect equity holders.  And three, if depositor losses have to be taken, its insane to take insured depositor money ahead of or even in parallel with uninsured deposits.


  1. marque2:

    Not that Cyprus with basically a left wing to communist government is actually running the country well. But my understanding is that the Cyprus banks are now failing as a side effect of some European policies regrading banking in Greece.

    That Cypress banks invested so much in Greece is also a failing, however if banks are failing due to government meddling, then yes the government has an obligation to bail them out. The answer is that Germany and the rest of the EU shouldn't have gotten involved in the first place. They should have let Greece and Spain go under. There would have been some pain, but the countries would have recovered by now - the bailout put them in a long term slow motion downward spiral instead.

  2. David Zetland:

    From an optimistic perspective, perhaps the theft of money from depositors will motivate them (and MANY others) to demand a change from politicians, to option #1. /hopefully yours...

  3. Tim:

    One minor correction: FDIC is actual insurance; in theory, member institutions pay premiums (http://www.fdic.gov/deposit/insurance/calculator.html) based on risk assessment.

    To be clear; the risk is backstopped by the general fund, but to call it a pure taxpayer bailout is a bit disingenuous.

    (Of course, the FDIC throws it's weight around and has forced mergers of undercapitalized banks before they fail. If that's good or bad is a different story.)

  4. marque2:

    Probably not. Cypryus is the closest to a Communist run government that they have in Europe.

  5. marque2:

    Just like flood insurance, the Federal government has not charged nearly enough money from the banks to cover the losses, hence the several bailouts of the last 30 years.

  6. anonzmous:

    exactly. Government regulators encourage banks to load up on government debt, so they do. The Cyprus banks aren't failing because Russians were depositing so much money into them. They were failing because the banks then invested that money in government debt, including a lot of Greek debt.

  7. Matthew Slyfield:

    Quite right. I wonder what would happen if the government eliminated FDIC and replaced it with a requirement that banks insure their depositors against losses but required the banks to acquire that insurance from the private insurance market?

  8. anonzmous:

    if lots of banks fail (as in Cyprus), the taxpayer will end up paying most of the price. In Cyprus, they can make depositors pay (large foreign depositors paying the bulk) or the local taxpayers paying for most of it. Remember, if the Russians can store their money somewhere else at a lower cost, they will. Folks pulling a couple hundred euro out of ATMs aren't the real bank run risk here.

  9. morganovich:

    i think he is leaving a key issue out of this: most Cyprus depositors are not Cypriots. cyprus is a banking black hole and a big tax haven. the banking deposits there are something like 10X gdp. most of it is foreign. why do you think russia is screaming bloody murder here? a new-found respect for law? npoe. it's oligarch money getting snatched.

    this is the EU waking up and saying "hey, let's grab someone else's money. oh, you can't vote here? too bad, so sad."

    this will break cyprus as a banking haven (which may have been a goal) and take money from russians, and tax dodging greeks particularly in the shipping industry.

    they will provide a holiday on these fees up to 20-50k eur to prevent most cypriots from getting dinged and then crank it up for the big foreign folks.

    i'm not championing this. i'd rather see them let the system fail, but i also think that to call this a simple reversal of the seniority of the capital structure misses the point. it's a grab of foreign money from targeted groups who lack any political say in the process.

    going to be a field day for the swiss and for the cayman islands.

  10. LarryGross:

    never quite heard whether or not the FDIC approach is good one or not. I think it is. It's survived the rest of time compared to other methods.

  11. LarryGross:

    geeze.. "test of time"

  12. jdgalt:

    According to telegraph.co.uk and several other sites, this new surprise tax on bank balances is causing a complete run on Cyprus' banks. Most of their ATMs were empty by Saturday (today, Monday 3/18 is a holiday there), and the run will continue unless the tax is rescinded.

    Hell, the very precedent it sets makes me want to empty out my account here in the US and stuff it all under my bed. I hope the Federal Reserve learns from this and doesn't try it.

    I also hope I'm not the only one reminded of FDR's seizure of Americans' gold in 1933 (which he similarly declared on a Saturday when the banks were closed, then had authorities invade every safe deposit box in the US to seize any gold people kept there). It can easily happen again, either here or in Europe, and FDR is Obama's hero. Get your gold home and do it yesterday.

  13. jdgalt:

    Harry Browne described the FDIC approach in his 1971 book "How to Prepare for the Coming Devaluation."

    Summary: FDIC has nowhere near the funds it would need if even one really large bank (Chase, B/A, Wells Fargo) were declared insolvent. It can call on the Fed for more funds but even that number is way too small (and it's iffy if Congress would raise it at the last minute, though they can). Therefore, the only thing that really protects you from a run on the banking system is that most people see the FDIC sticker in the window, assume "duh, I guess it must be safe!" and don't rush in to take their money out. Browne called this "the sticker principle."

    But it may only take one stupid intervention like this tax in Cyprus to make everybody rush in to take their money out anyway.

  14. john mcginnis:

    It won't be the Fed that authorizes it. It will be Congress.

  15. john mcginnis:

    They do, its called a CDS.

  16. john mcginnis:

    Problem is the holdings were demoniated in Euros. The Eurocrats could not let the Euro be affected. Hah!

  17. ErikTheRed:

    It's not outside the realm of possibility that Comrade Putin has a decent stash there as well. If we see certain Eurocrats start dropping dead, I won't be shocked. It's not smart to yank the chain of somebody that evil and powerful.

  18. ErikTheRed:

    It will be interesting to see if or when this starts shifting reserves to Bitcoins, which can be used as easily (if not nearly as widely, yet) as credit cards, yet circumvent the entire banking system. You can keep your wealth locked up on an encrypted USB stick (hopefully with a backup or two), no financial institution required.

    I'm not entirely sold on Bitcoins as a store of wealth, but this may push things in that direction.

  19. Matthew Slyfield:

    No, a CDS is a hedge that is supposed to protect the bank, not the depositor.

  20. LarryGross:

    correct. You could charge a fee on every transaction FDIC-like and have a fund to compensate depositors - and just adjust that fee according to casualty losses if folks were really serious about protecting depositors but much of this is about getting money from the depositors one way or the other - and that's before the govt gets involved - at the later stages when they are supposed to step in and make depositors whole but the damage is far too great.

  21. mesaeconoguy:

    Exactly. One of the rationales speculated behind this course of action was that Cyprus is a parking lot for hot Russian money


  22. Matthew Slyfield:

    If the banks were required to have sufficient private insurance to make all of their depositors whole in the case that the bank went under, the insurance companies would probably do a better job than the government has of keeping the banks out of overly risky investments.

  23. LarryGross:

    in theory. In practice, we get banks colluding with insurance companies and rating agencies like we saw with the securitized mortgage meltdown.

    During this whole time when the industry was self-destructing, the FDIC did their mission as designed and protected the country from a run on the banks.

    pity, we did not have similar framework for the non-FDIC banks, eh?

    who do I trust - the FDIC or the corporations? no contest - FDIC

  24. Brian:

    In addition to bailing out shareholder and bondholders with taxpayer money, it will protect them by giving depositors a haircut as well.

    Everywhere I see mention of this story, I see this word "haircut". Why are commentators so afraid to call it what it really is? "Stealing," "theft," and "robbery," I think are all far more accurate descriptions of what's going on here than a silly analogy like a "haircut".

  25. marque2:

    That is an interesting rewrite of History. I notice how there is no government culpability whatsoever. No mention of demanding Fanny and Freddy support substandard loans. No mention of forcing banks to give loans in poor areas, even when the folks in those areas couldn't support home ownership. No mention of the government funding Acorn to sue banks to give bad loans. No mention in the governments culpability in insisting that home loans were "good investments that banks should invest in to get good ratings from government regulators.

    No mention that much of the derivatives crisis was from banks trying to cover their @sses from the inefficient government demands imposed on them.

    I know the bankers weren't saints but please lets let pass the blame fairly. The bankers were only really reacting to distortions created by our government in the first place.

  26. mesaeconoguy:

    That isn't what happened, moron.

  27. mesaeconoguy:


    The entire episode was moral hazard writ large, and created by government (leftists, primarily Henry Gonzalez, Andy Cuomo, Bawney Fwank, Henry Cisneros, and Jim Johnson).

    Banks responded to the incentives.

  28. mesaeconoguy:

    Here is the critical detail:

    “the EU countries rely on their major banks continuing to
    leverage up their balance sheets to buy more government debt. The
    implicit deal here is: You banks expand your balance sheets and buy our
    debt, and we will shelter you and prevent external shocks from toppling you in
    your increasingly precarious, over-leveraged position.”

    This is also why Euro banks never recapitalized after the 2008 meltdown, and are significantly more vulnerable than US banks currently. Many large Euro banks are effectively insolvent right now.

    The question is how far the contagion will spread – if we see bona fide bank runs in Spain, Italy, and Portugal, it’s game over for the Euro.

    The odds of that outcome seem to be increasing daily. My guess is that outcome is 55 – 60% likely at this time.

  29. Thane_Eichenauer:

    I imagine most commentators don't see it as stealing, theft or robbery (especially if it isn't happening with their money).

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