Guest article: Banking lessons from Cyprus

However, the imposed capital controls and the "haircut" have the positive effect of directing public attention to the essence of fractional banking and the fact that the "conservative" method of saving - the bank deposit - is in practice a loan to institutions that cannot possibly fulfill all their obligations and need legal privileges, bank "vacations" and a lender of last resort to survive in the long term.

The confiscation of an as yet unspecified portion of bank deposits in Cyprus has sparked a justifiable wave of indignation, although it is difficult to see any essential difference from ordinary taxation, the “social security” pyramid and the hidden inflationary redistribution of wealth. Nevertheless, the imposed capital controls and the “haircut” have had the positive effect of directing public attention to the nature of fractional banking and the fact that the “conservative” method of saving – the bank deposit – is in practice a loan to institutions that can in no way meet all their obligations and need legal privileges, bank “vacations” and a lender of last resort to survive in the long term.

One of the core competencies of banks is to examine the solvency and reliability of potential borrowers. Any profit from financial intermediation is derived from the difference between interest earned on loans and interest paid on deposits, minus losses on bad debts. Whether a bank makes a profit or a loss from this activity depends solely on the extent to which management’s forecasts are confirmed, i.e., as in any other business. To ensure its viability and liquidity, a bank must follow the “golden rule” formulated by Mises almost exactly 100 years ago: the maturity of liabilities should not precede the maturity of receivables[1].

Current accounts and the de facto equivalent savings deposits, which allow withdrawals without notice and without penalties, have a practically instantaneous maturity. That is, in order to be able to fulfill its contractual obligations, the bank would have to keep 100% of these amounts at its disposal at all times. Unlike the classic savings deposit, in the above cases the holders do not give up the use of the funds, they hand them over to the bank solely for reasons of security and convenience. Current accounts are thus transformed into perfect monetary substitutes[2] – the owner considers them in the same way as banknotes in his wallet, and non-cash payments are accepted with the same readiness as cash.

From their own experience, banks can derive a rough rule of thumb for the expected need for cash for everyday transactions, and any excess can be used for additional income through credit expansion. This is where the name fractional reserve banking comes from, which creates cash equivalents out of thin air. This blurring of the lines between savings and checking accounts should be obvious from the fact that the latter also earn interest, albeit minimally. Still, it is hard to imagine a bank paying even a token sum to a customer to keep their valuables in a safe deposit box if there is no benefit to them.

Leaving aside the fact that this constitutes abuse of someone else's property, the venture also carries serious risk - the repayment is agreed for the future, and is uncertain to some extent, especially if it is Greek government debt, as in the Cypriot case. Modern "Austrian" economists call this practice maturity mismatching[3], as short-term liabilities combined with long-term and/or risky receivables are at the root of many financial collapses - as a result of one of the latter, the banking system of Iceland collapsed[4], and Cypriot depositors are currently awaiting the arbitrary decision of bureaucrats as to who exactly will lose how much. Instead of all creditors and owners of insolvent banks bearing the consequences of their decisions, deposits over €100,000 (which presumably belong to bad people) in all banks will be heavily taxed, under the dubious pretext, to say the least, that this confiscation, along with other restrictive measures, will stabilize the Cypriot banking system.

It seems more plausible to assume that the “saving” of deposits up to 100,000 euros aims to maintain confidence in the state guarantees on them. However, the same are at the root of the problem. Like any intervention in the market, the state guarantee of deposits, which in essence represents “free” credit default swaps, suffers from a number of unintended consequences. The most important of these is the stimulation of highly speculative investments by banks, since depositors view every deposit as completely risk-free, no matter how exactly the bank manages their money. In a free market, banks would compete mainly in the area of security, because risky institutions would be forced to offer higher interest rates to attract depositors.

Ultimately, all banks operating with partial coverage are effectively bankrupt. If all depositors were to withdraw their savings at the same time, every bank would be insolvent. The fact that this usually does not happen simultaneously does not change the nature of the situation. The deliberate actions of thinking individuals cannot be predicted[5] and there is no way to know exactly when people will lose confidence in the banking system and a bank run will follow. And if the desire of bank customers to get what is contractually theirs is the banker’s nightmare in the current institutional landscape, then perhaps it is time to think about reform. Or as Rothbard puts it:

“Banks should be obliged to comply with their obligations, like any other business. Any intervention against bank runs that occur will establish the banks as a privileged group, exempt from paying their debts, and will lead later to inflation, credit expansions and depressions. And if, as we maintain, the banks are in a congenital state of bankruptcy and the mass withdrawal of deposits simply reveals this insolvency, it will be beneficial to the economy if the banking system is reformed, once and for all, by a radical purification of fractional banking. Such a purification will clearly illustrate the dangers arising from fractional banking and will insure against future banking evils much more than any academic theories.”[6]

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