Rather than tax deposits and threaten stability of financial system, use deposit guarantee as basis for ending financial crisis

A Reuters poll reveals that 20 out of 22 economists and bond strategists see the Cyprus deposit tax as undermining both the deposit guarantee and the stability of the EU financial system.

This poll confirms what your humble blogger has been saying about how a modern banking system is designed so that banks can operate with low or negative book capital levels.

Why does this poll confirm this statement?

Because everyone in Cyprus already knows that the banks are insolvent (the book value of their liabilities exceeds the market value of their assets) even if the bank regulators have taken steps so that banks do not show this reality in their financial statements.

What is going to cause the run on the banks not only in Cyprus but across the EU is not the banks being insolvent or having a negative book capital level, rather it is the tax on the deposits to cover the losses that the banks' incurred.  This tax effectively ends the deposit guarantee which is suppose to protect depositors from bank losses.

So long as the deposit guarantee is in place, depositors are completely insensitive to the solvency/insolvency or book value of the bank.

This is behavior that was learned from the depositor's parents when they first opened up a bank account and asked how do they know they will be able to get their money back and were told that the government guarantees they can get their money back.

This behavior shows up when you ask people do they know what the total amount of shareholder equity at their bank was at the end of last quarter.  Virtually no one knows including the economists, regulators and central bankers who are campaigning for banks to hold more capital.

Why don't they know?  Because if you keep your deposits below the government guarantee, there is no reason to know or care.

This observation has important implications for how policymakers should respond to a financial crisis where there is a significant amount of excess debt in the financial system.

Your humble blogger was the first person in the world to talk about how deposit insurance makes it possible for the banks to protect the real economy by absorbing all the losses on the excess debt in the financial system.

Yes, the banks will have negative book capital levels.  But absolutely no one cares (except the bankers as it restricts their cash bonuses).

Ending this financial crisis is easy.  Rather than destroying the deposit guarantee, use the deposit guarantee and have the banks absorb the losses on the excess public and private debt in the financial system.

A proposed levy on deposits in Cyprus would pose a threat to the financial stability of other vulnerable euro zone countries, according to a near-unanimous sample of analysts polled by Reuters. 

Twenty out of 22 economists and bond strategists surveyed since Monday said a tax on deposits risks undermining the banking systems of other countries threatened by the euro zone debt crisis....

In theory, euro zone deposits up to 100,000 euros are guaranteed, but analysts warned the proposal of a levy risked debasing that principle, literally overnight. 

"The risk is that ... bank customers no longer trust the guarantee for private deposits in all member states of the European Union," said Gernot Griebling, head of bond research at German bank LBBW. 

"In the case that rumors on solvency problems of another bank come up, this might lead to a bank run." 

Jeroen Dijsselbloem, who chairs meetings of euro zone finance ministers, said any bailout of Cyprus, one of the currency union's smallest economies, will have to involve some kind of levy on depositors....