Britannia Radio

Europe’s banking confidence crisis

Published: October 1 2008 19:36 | Last updated: October 1 2008 22:17

Banks gather money and lend it out. Their ability to survive depends on the confidence of depositors. No financial institution could survive if all its depositors asked for their money at once. That is the risk facing Europe’s banks as the financial crisis that has engulfed Wall Street sweeps across the Atlantic. It is the reason why the Irish government, panicked by large-scale cash withdrawals on Monday, announced a blanket guarantee for two years on all deposits at six big banks and protection for other creditors including bondholders.

Ireland’s response is understandable. Faced with the possibility of the imminent collapse of one or more of its banks, what country would not do everything it could do to prevent it?

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If Dublin’s announcement was intended as an emergency confidence boost – the accompanying legislation that was being debated in parliament yesterday was suspiciously thin on detail – it appears to have worked. Shares in the banks, which had been in free fall, rose sharply in response. Spreads on the banks’ credit default swaps, a measure of financial stress, narrowed.

Indeed, some institutions are dealing with increased inquiries from depositors considering opening savings accounts. Many of these potential new customers live outside Ireland.

Therein lies the problem. The scale of the protection promised by Ireland exceeds by far that of any other European Union nation. In the UK, for example, the first £35,000 of individual deposits are protected, though forthcoming legislation will raise the limit to £50,000.

It is true that Ireland, like all EU member states, is responsible for the stability of its banking system. But this is not justification for a guarantee that, as the Irish finance minister himself acknowledges, amounts to economic nationalism. His defence – “we’re on our own here in Ireland” – shows scant regard for Dublin’s neighbours. The government has behaved anti-competitively and the protection it is offering could even destabilise other banks.

Depositors worried about the security of their savings now have every incentive to withdraw money from existing accounts and shovel it into the protected Irish banks, whose overseas subsidiaries will also be covered by the scheme. That increases the risk of a run on banks outside Ireland.

Other European governments will come under pressure to match the Irish promise. In the US, too, there are plans to raise the compensation ceiling to $250,000 to try to win the support of reluctant Republicans and Democrats for the Wall Street bail-out plan. But blanket guarantees should be resisted. Even if pan-European agreement could be reached on levels of protection, the Irish scheme looks deeply flawed.

There is a clear and urgent need for steps to shore up confidence, as well as capital, in the banking system. Fortis and Dexia in Belgium, Germany’s Hypo Real Estate, Iceland’s Glitnir and Bradford & Bingley in the UK will not be the last institutions in search of rescue from national governments. But, if taxpayers are to bear the risk for government bail-outs, they should be fully and adequately compensated.

It is far from clear how the Irish scheme would achieve that. In fact, the main danger of its guarantee is that a bank’s management, in the knowledge that the taxpayer stands behind all its liabilities, will have every reason to take bigger risks: an unacceptable degree of moral hazard. Such protection for creditors and depositors should at the very least be accompanied by tough controls on how the banks are managed.

Ultimately, the debate over depositor protection is a distraction from the underlying causes of failing confidence in the banking system: unpriceable assets and heavy losses. Central banks are already doing everything they can to unfreeze the credit markets by providing huge amounts of liquidity. If European taxpayers are to bear the risk of banking failures, as they have this week, then one solution is for governments to address the need for capital infusions into banks.

Rather than offering blanket guarantees, governments should take a more surgical approach. They should be prepared to inject equity into vulnerable institutions by buying stakes with preference shares, as the investor Warren Buffett has done with Goldman Sachs. These would pay a dividend at a punitive rate and would be combined with a sufficient degree of supervision of the management by the regulators to protect taxpayers’ interests.

It is important to prevent panic breaking out. But policymakers must spend more time on treating the causes of the financial crisis and not just the symptoms.

Copyright The Financial Times Limited 2008