Specifically, I have asserted that deposit guarantees make the taxpayers the 'silent equity partner' of the banks when the banks have low or negative book capital levels.
Why?
Because the government is both explicitly and implicitly on the hook for making the depositors whole.
More importantly, depositors assume that governments will honor their deposit guarantee. From the time they open their first bank account they are told not to worry about bank book capital levels (please recall, when a 6-year old opens a bank account, their parents answer their question of how do they know they can get their money back by saying the government guarantees the 6-year old will get their back and not "look at a bank's financial statements and if the book capital level is positive....).
The case of Iceland and its handling of deposit guarantees confirms the expectation that government's will honor their deposit guarantees.
However, the case of Iceland reminds everyone that foreign depositors who only have an account at a bank to earn a higher rate of interest should recognize that they are "investors" and as investors they should not assume that they will be repaid under the country's deposit guarantee program.
As reported by the Wall Street Journal,
Iceland won a sweeping victory in a court fight over its responsibilities to foreign depositors in the Icelandic bank Landsbanki, which failed in 2008.
The court of the European Free Trade Association on Monday said Iceland didn't breach European Economic Area directives on deposit guarantees by not compensating U.K. and Dutch depositors in Landsbanki's online savings accounts, known as Icesave accounts....
The EFTA Court sets up a vexing question: If deposit-guarantee programs don't protect everyone, are they really effective?
That issue was raised by the European Commission, the EU's executive arm, which joined the case against Iceland....Yes, deposit-guarantee programs are still effective even if they don't protect everyone.
They are effective even with a distinction between "depositors", individuals and firms that have a reason other than interest earned for having money at a bank, and "foreign investors", who have money at the bank solely for the purpose of receiving a higher interest rate.
Foreign investors recognize that under the FDR Framework the principle of caveat emptor (buyer beware) applies and they are responsible for all losses on their exposures. Hence, they have an incentive to independently assess the risk of investing money in a bank of a small country.
Because its banks opened Internet arms seeking deposits from foreigners, Iceland had an unusually high proportion of foreign depositors in the system.....These foreign depositors were investors.
Iceland didn't force losses on domestic depositors. In the windup of the banks, the authorities put domestic deposits and assets into new "good" banks and left foreign deposits in the old, insolvent banks.
The EFTA Surveillance Authority argued that Iceland violated nondiscrimination rules by treating domestic depositors differently.
The court agreed with Iceland that the transfer didn't break the rules.
The EU's common-market rules require that every country establish a deposit-guarantee program that provides a minimum level of compensation to savers in case of a bank failure.
Iceland's banking collapse took down all the island's major banks, and the Icelandic deposit-guarantee fund didn't have nearly enough money to pay out insurance.
At the core of the Icesave case is exactly what a country must do in such a total failure.
Iceland said its obligation was simply to make sure that a reasonable guarantee plan existed. The U.K. said a country is obliged to make sure that insured depositors are actually paid.
The Icelandic government expressed "considerable satisfaction" that the country's stance had prevailed in the Icesave case....
By compensating their depositors, the U.K. and the Netherlands received priority claims on the assets of the failed Landsbanki. The ministry said it expects those assets will be enough to pay all the British and Dutch claims.
A spokesman for the European Commission, Stefaan De Rynck, said the commission would "maintain its interpretation" of the deposit-guarantee requirements in the 27 member states of the EU, where Mr. De Rynck says the guarantees must "also apply in the event of a systemic crisis." ...The message from the EU being that both "domestic" depositors and "foreign investors" can expect an EU member states deposit guarantee to cover their bank deposits.
The Icesave affair has been an acrimonious backdrop to Iceland's relatively successful attempt to recover its economic footing in the aftermath of 2008....Iceland adopted the Swedish Model and required its banks to recognize upfront the losses on the excess debt in the financial system. By sparing its real economy the burden of servicing this excess debt, Iceland has seen its real economy bounce back quickly.
The British shelled out £2.35 billion ($3.7 billion), and the Dutch €1.32 billion, to repay their depositors in Landsbanki shortly after it collapsed....
As it became clearer that Landsbanki's assets would cover most, if not all, of the balance, the impact of the dispute faded.....
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