Public's faith in banking vital to its survival

Banking stability is unattainable until the special guarantee is removed, writes Bill Hobbs

Three years ago we trusted banks so much most of us didn’t know of the 1995 deposit protection scheme designed to guarantee compensation to ordinary people, albeit only up €20,000. Billions in household savings with credit unions weren’t covered at all. But that was then.

In 2008 a Rubicon was crossed and there is no going back. It’s not enough for banks to be safe – we need to feel they are safe. Many a bank has been forced to close, not because it was inherently insolvent but because people believed it was. As most people cannot tell a good bank from a bad bank, perception accounts for 100% of trust. Undermine perception and people will only deposit with a bank if their money is guaranteed by the state. In effect, state guarantees stand in for trust in banking and once provided take a long time to safely remove.

As trust in our deposit taking institutions evaporated it was replaced by the Government’s twin deposit guarantee mechanisms. The first is the deposit guarantee scheme which protects up to €100,000 per participating institution.

Designed for normal times, it’s a form of co-insurance system through which its member banks and credit unions insure one another. If the co-insurance system runs short of money or cannot be replenished without undermining its members, the Central Bank may step in.

The second mechanism is a special temporary guarantee for the balance of deposits over €100,000. Extended earlier this year to December, it will undoubtedly have to be extended further.

A state’s financial safety net is designed to do two things; ensure financial stability by preventing banks reckless risk taking; and persuade its citizens not to rush to take their money out at the first sign of trouble. To work the safety net has to have three parts.

Robust laws, regulations and effective prudential supervision; a lender of last resort who provides temporary liquidity support; and deposit insurance to cover some but not all of ordinary people’s savings should a bank fail. These three components are supposed to protect savers’ funds from losses by ensuring financial stability through controlling banks’ risk taking.

Prudential supervision here having failed to ensure financial stability, helped trigger a crisis and the infamous Government blanket guarantee in 2008. Had it not been for ECB lender of last resort assistance since, making available tens of billions in liquidity support, our banks and credit unions would have shut down. And given that deposit protection schemes aren’t designed to deal with a system-wide crisis, the blanket guarantee had to be extended to ordinary people to persuade them not to rush to take their money out.

Since then, both the ECB liquidity lifeline and blanket guarantee has kept our domestic banking systems’ doors open. But banks will have to be weaned off the ECB liquidity lifeline and the special guarantee retired.

For now the supervisory pendulum has swung from the pre-crisis regulatory and political captivity of banking to a post-crisis captivity of banks by the regulatory and political system.

Many bankers have a genuine and legitimate fear the pendulum may get stuck in politically inspired, risk adverse prudential supervision for the next decade. Once banks recover their ability to generate credit again bankers may be unwilling to lend as they may fear making bad loans.

State ownership exacerbates this problem as it may act to stifle normal risk taking. Conversely it may also encourage recklessness as political pressure to finance favoured industrial or services sectors could cause another credit bubble.

On the hook for guaranteeing current and future moral hazard, the Government may find it impossible to wind down the quite extraordinary and unprecedented explicit blanket guarantee when the constructive ambiguity of “we might have to step in to bail out a bank, but only if its too big to fail” became a concrete promise to bail them all out.

The bottom line is this, banking stability will not be achieved until the special guarantee is removed and banks are once again trusted as safe places to deposit money.

Government’s four year austerity programme will not work unless and until banking stability has been achieved.

For now the special guarantee carries an economic cost reflected in the states’ stratospheric bond market prices that reflect banking and economic inter-dependent risks. Bond markets and sophisticated depositors realise that like the chicken and egg, economic and banking stability are co-dependent on each other for survival.

A version of this article appeared in the Irish Examiner, Business Section on Monday 11th October 2010.