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Botched bailout lifts veil on banking confidence tricks

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Modern banking depends on two confidence tricks. Banks tell customers they can withdraw all their cash when they want and governments pledge to step in if anything goes wrong. The problems in Cyprus show that both promises are sometimes broken. The breach of faith is not only a problem for the state's 800,000 inhabitants, but sets a worrying precedent wherever there are too many banks and an overindebted government. The question is what can be done to restore faith in the system – or to promote a more stable alternative.

Confidence tricks are as old as banking itself. Merchants in medieval Venice lent out coins that had been deposited with them; so did goldsmiths in 17th-century London. As long as trust is not broached, the use of short-term funds to finance longer-term loans – a process known as maturity transformation – helps promote investment and growth. But the system is inherently fragile.

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The crisis of the Depression led to the invention of the second confidence trick. The United States introduced deposit insurance, effectively putting the government's credit behind that of its banks. The idea has since gone global. According to the World Bank, the number of countries offering explicit guarantees to bank depositors expanded from 12 in 1974 to 88 in 2003. Guarantees have also increased: the U.S. Federal Deposit Insurance Corp. (FDIC) now covers savers up to $250,000, up from $40,000 in the early 1980s. The European Union has a blanket guarantee of €100,000 ($120,000) – though this remains the responsibility of national governments. For Cyprus, the promise was empty. Its insured deposits are close to €30-billion, a sum its President admitted the country could not raise.

Cyprus is an extreme case. The country was a haven for foreign cash: at the end of 2011, banking assets were eight times GDP. Domestic lenders also funded themselves almost entirely with deposits, which meant there were few shareholders and bondholders to absorb losses. Even though Cyprus belatedly decided not to tax insured deposits, savers may no longer trust the government's guarantee. Some form of capital controls may be needed to stop more cash from fleeing.

On the face of it, Cyprus reinforces the case for the current thrust of international bank reform. This requires lenders to finance themselves with more equity – there is a debate about how much more – and by holding larger buffers of liquid assets. If banks fail, regulators should be able to safely wind them down rather than bailing them out. Assuming these reforms are completed, they will have two big benefits. They recognize that banks are prone to failure, and limit the bill for taxpayers when things go wrong.

Even then, however, the explicit promises made by governments to depositors remain extremely large. At the end of 2011, the FDIC insured deposits of close to $7-trillion (U.S.) – almost half of U.S. GDP. In a pinch, the United States can always print more dollars – an option that is not open to Cyprus or other members of the euro zone. Worse, deposit insurance itself may be adding to financial crises. After all, savers who know they will be bailed out have little incentive to distinguish between risky and safe banks. This encourages banks to take a more cavalier approach to fundraising.

What's the alternative to governments insuring banks that lend long-term and borrow short-term? There is no shortage of radical proposals. The British economist John Kay has suggested creating "narrow banks," which could only invest deposits in sovereign bonds. Laurence Kotlikoff, the U.S. academic, thinks loans should be financed by investments of equivalent duration. Some argue that online peer-to-peer lending networks could perform this function. These proposals have one common theme: they would no longer require banks to engage in maturity transformation.

There are two big objections to these ideas. The first is that bank-like behaviour isn't limited to deposit-taking institutions. The promise of a healthy return and instant access to cash is hard to resist. Lehman Brothers successfully conducted this conjuring trick in the wholesale financial markets, until it collapsed. More recently, exchange-traded funds have offered investors the illusion of instant liquidity in hard-to-trade junk bonds. Maturity transformation could prove hard to stamp out.

A more fundamental concern, however, is that banking's confidence tricks are deeply entwined with several centuries of economic growth. We simply do not know what a modern economy would look like without them.

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That does not mean, however, that the survival of deposit-taking banks can be taken for granted. If savers lose confidence in both banks and the government that stands behind them, the system collapses. This is not unprecedented: deposit-taking banks thrived in Venice for several centuries but a string of failures meant they had all but disappeared by 1600. In exposing banking's confidence tricks, the Cyprus mess creates the risk of a similar retreat.

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