Bank runs in the periphery: why they matter and how to stop them

Lots of attention over the last few days on deposit outflows from Greek banks, an acceleration of the slow-motion bank run of the last two-and-a-half years that saw €95bn of deposits leave the country’s banks between September 2009 and March 2012 (i.e. more than one-third of Greek banks’ peak €282bn stock of deposits).

In spite of the deposit flight, the Greek banks have continued to fund themselves through ECB/ELA facilities. So why exactly does this matter?

Tyler Cowen explained the point well in this article looking at similar deposit outflows from the Irish banks:

This flight of capital reflects a centuries-old economic principle known as Gresham’s Law, sometimes expressed casually as “bad money drives out good money.” In this context, if two assets — euros inside and outside Ireland — are not equal in value in the eyes of the marketplace, sooner or later the legally fixed price parity will fall apart.

If enough depositors fear frozen accounts, the banks will be emptied out, and they also will require additional government bailouts, on top of the bailouts for the bad real estate loans. The banks come to resemble empty shells, conduits for public aid but shrinking and unprofitable as businesses — and, to a large extent, that is already the case in Ireland. Portugal is moving in this same direction, toward being a land inhabited by zombie banks.

Essentially, if you think about bank deposits as distinct financial assets, it becomes clear that the value you would place on a euro held in a bank with a low risk of default is different to that of a euro held in a bank with a high risk of default. But as there’s a fixed legal parity between the price of a euro in the two banks, which prevents prices adjusting, the quantity takes the full brunt of the adjustment instead:

Within a currency union, this problem is usually solved through bank deposit guarantees. We’re content to treat sterling deposits in HSBC, RBS or Manchester Building Society as equivalent assets, despite the very different business models of these banks, because the UK Financial Services Compensation Scheme (FSCS) stands behind their retail deposits (at least up to a limit) – and the UK government ultimately stands behind the FSCS.

But within the euro area, deposits guarantees are still done on a national basis. Deposits in German banks are guaranteed by the German authorities and deposits in Greek banks by the Greek authorities. And the German deposit guarantee is patently going to be more creditable than the Greek scheme –  particularly once euro exit concerns are brought into play.

The pre-crisis assumption that bank deposits in different parts of the euro area were equivalent was therefore clearly as misguided as the assumption that different euro area governments had the same (low) credit risk. And, as with credit risk on euro area governments, I don’t see how investors will ever go back to the old assumption unless there is a fundamental change to the structure of euro area banking.

Alongside some form of eventual fiscal union, I therefore think the euro area will need to introduce a form of mutualised deposit guarantee as a necessary condition for preventing a future crisis once this one is over. Indeed, it may even be a necessary condition for ending the current crisis, given the lending and growth implications for Europe of this breakdown of the monetary system. Returning to Tyler Cowen:

It’s the zombie banks that doom the current European bailout plans. On any single day, or even for a year or two, an economy can survive with zombie banks, but over time functional domestic banks are needed to allocate credit.

If they don’t find a way to return to a situation were euros in German banks and periphery banks are valued equally, deposit flight and the consequent dearth of credit will continue – and bang would go hopes for Spain.


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