A slippery problem
Civitas, 21 February 2011
It was reported over the weekend that the Icelandic President Olafur Grimsson, has called for a national referendum on the new plan for repaying British and Dutch loans made as a result of the ‘Icesave’ fiasco. The two countries loaned Iceland €4 billion to bail out the country’s deposit insurance scheme, which could not afford to compensate British and Dutch depositors, when the Icesave savings scheme collapsed. Aside from the political ramifications of the on-going dispute, it raises wider issues about international financial supervision and insurance schemes, as well as a more pressing problem about financial responsibility.
The current dispute stems from a disagreement, during the financial crisis, over who should compensate, and to what extent, foreign depositors who had placed funds in Icelandic banks. In particular many British and Dutch depositors had placed money in the Icesave savings scheme run by the Icelandic bank, Landsbanki. Initially attracted by the above average interest payments provided by Icesave savings and investment accounts, depositors later found that the bank was insolvent when the financial crisis affected its supply of wholesale funding. A spat broke out between the Dutch and British Governments and the Icelandic Government over who was expected to compensate depositors. In particular, problems arose because of a lack of clarity in an EU directive (applicable to Iceland as a member of the European Economic Area) which did not clearly stipulate who would compensate depositors if a national depository scheme failed. The reserves in Iceland’s scheme were insufficient to cover the deposits of the Dutch and British savers. Eventually Britain and the Netherlands agreed to loan Iceland the money to compensate depositors, however it was not agreed how Iceland would pay this money back, and this still has still not been agreed.
The current dispute raises a number of issues. One: who should regulate global financial firms? Currently firms are regulated by-and-large by national regulators, however neither the Icelandic regulator, nor the FSA saw the problems of the Icesave scheme. The FSA will argue that it does not have the jurisdiction to examine a scheme provided by a foreign-owned and foreign-located bank. However, it is also clear that the Icelandic government, and Icelandic regulator, did not feel the same degree of concern for foreign, as opposed to domestic, depositors, and so did not adequately regulate a scheme marketed to foreign customers. There are many issues with international financial regulation, and many countries, not least the UK, wouldn’t welcome other countries dictating regulatory conditions in an important (particularly important in the UK) area of their economy. However, it is clear that without some measure of regulatory coordination and cooperation, financial activity, often the most risky kind, will locate to regulatory havens, where opaque practices will not be investigated.
A further problem concerns insurance against financial insolvency. In the Icesave case it is clear that there was a disagreement over who should compensate depositors. Currently each EU state must guarantee bank deposits in their country (whether they are held by domestic or foreign residents) up to a limit of €50,000. This would seem to make sense, most countries provide an insurance fund from levies on banks operating in their country, so each country will be able to cover losses from these banks in the case of insolvency. However, a bigger problem arises when an international crisis creates insolvencies which cannot be covered by a national scheme, when such events occur it is not clear which taxpayers are liable and to what extent.
The final problem is arguably the most intractable, and concerns the justification for insurance itself. Insurance for depositors creates stability; bank runs are less likely if depositors are confident about the safety of their money. However it is not clear why depositors get free insurance on their money. At first it would appear fair that depositors should be insured; they have done nothing more risky with their money than deposit it in a bank. However, depositors expect interest on their savings, interest which can only be generated by a bank that makes investments, which are risky, to varying degrees. Some may argue that banks pay for insurance (through a levy which funds deposit insurance), and that by doing so they get the privilege of lending out deposits to generate returns, for themselves and their customers. If this is the case then to what extent can banks lend money? It was clear that during the build up to the crisis, the credit provided by the majority of banks increased dramatically. It is clear that this increase was powered by leverage, an increase in debt rather than the deposits or equity base of banks. Was such leverage and the accompanying increase in risk, justified by the levy paid by the banks? In light of the massive tax-payer bail-outs of many large banks, very few would argue that it was.
This is the real issue here, while international regulation and international deposit insurance are pressing concerns, these pale in comparison with a greater problem: to what extent should banks, and bank customers, be protected from their own decisions? Banks that have de-facto government support have less incentive to moderate risky behaviour, similarly consumers who do not have to worry about the success of their bank have no incentive to judge its stability. Furthermore the perennial problem, inherent in fractional reserve banking; as seemingly allowing both liquidity and high returns, yet complete safety, continues to go unresolved.