Wednesday, April 4, 2012

The key to handling a banking crisis is to keep confidence of depositors

Ultimately, in a bank solvency led financial crisis, the key issue is maintaining depositor confidence.  This is important because if depositors lose confidence, it triggers a downward economic spiral.

As shown by Ireland, Greece and Spain, lending to and growth in the real economy declines as a result of a run on the deposits of the banking system.

The question is how to maintain depositor confidence.

The Japanese and Swedish models for handling a bank solvency led financial crisis offer different answers.

Under the Japanese model, depositor confidence is equated to the level of bank book capital on the theory that if bank book capital declines so too will depositor confidence.  As a result, policies like government capital injections have to be pursued that protect the level of bank book capital.

Under the Swedish model, depositor confidence is equated to the perceived strength of the deposit guarantee on the theory that depositors don't care if a bank has a positive or negative book capital position so long as their deposit is safe.  As a result, policies are pursued that protect the real economy from the losses on the excesses in the financial system and, by doing so, the creditworthiness of the government deposit guarantee.

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