Why is US government mulling guaranteeing 100% of Bank Deposits and its consequences...

The idea

A notion is being floated that US Government may guarantee all the deposits in US banks, so that bank run can be prevented. Two banks have already failed and a third one is showing great instability. If Economists are to be believed, fifty to hundred US Banks are in the que for failure, ultimately leading to bankruptcy. For the two banks that have failed US Government has indicated that all the depositors will be protected by the US Government, even beyond the limit of the insurance on the deposits provided by the US financial system.

Current system of managing the risk

Deposit insurance is one of the significant benefits of having an account at a Federal Deposit Insurance Corporation (FDIC) insured bank, in the event of a bank failure.?The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. Many deposits are uninsured also. But people having deposits above the aforesaid limit of $250,000 are likely to take a hit or haircut in the form of deposits which will never be repaid back to them.

This is how the capitalist system spread the risk of the system among various stake holders. In case of a bankruptcy, the shareholders of the bank lose their entire money and the deposit holders lose a part of their money, who are basically creditors of the bank.

System in India

The same is the system in India. In India the Deposit Insurance and Credit Guarantee Corporation (DICGC) plays the same role as FDIC in USA so far as deposit insurance is concerned. ?The DICGC insures principal and interest up to a maximum amount of five lakhs (6100 USD). Rest of the risk is with the depositors of the Bank.

Basic reason for failure of US Banks

The basic reason for failure in the current spell is continuous increase in the interest rate by the Federal Reserve of USA for last many quarters to check runaway inflation. As a result if any bank had purchased any bond earlier bearing low coupon (interest), the market price of those bonds have reduced in the current high interest scenario. But that is a notional loss, because many of those bonds have not reached maturity. However, if because of bad cash flow management, or maturity mismatch, if any bank has to sell those bonds, it will have real loss, which have to be put in its book. A net loss in the book of any bank creates panic and depositors start withdrawing money.

The 100% Deposit Insurance Proposal

The proposal for 100% deposit insurance in USA was made by no other than Elon Musk, the number 1 billionaire of USA, and second richest person of the world. ?

As per a report of Bloomberg last week “US officials are studying ways they might temporarily expand FDIC coverage to all deposits, a move sought by a coalition of banks arguing that it is needed to head off a potential financial crisis.”

It may be mentioned that for the two banks already failed FDIC has agreed to give the depositors 100% protection against the deposited amount. Treasury Secretary Yellen said “Similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion," in a speech to the American Bankers Association.

So depositors of all smaller banks can remain assured that they will get 100% protection. What is left out are the big banks where many of US billionaires and millionaires have their money including perhaps Elon Musk. It is possible by change of circumstances, USA may also provide 100% guarantee to the depositors of the big banks mainly because of ?two reasons :

(a) Big banks are pursued to divert some resources to the small banks to prevent their failures

(b) merger of smaller banks with bigger banks to prevent bankruptcy cannot be ruled out.

If big banks fail, the share market will fall and the net worth of all the big industrialists and politicians of USA will reduce substantially and also the economy will go into a recession killing demand, industrial growth and employment. If any systematically important bank fails, the entire economy of USA will be threatened and hence providing 100% guarantee to the systematically important banks cannot be ruled out if the situation worsens.

Situation in Europe

In Europe in Switzerland, Credit Suisse, was a systematically important bank at global scale. In matter of weeks the bank showed such weakness that the government was forced to merge it with another systematically important bank UBS, making the shareholders of Credit Suisse to take large haircuts and the AT1 bondholders (17 Billion USD ) of Credit Suisse turned pauper. In spite of that the problem in the EU banking system is not over. Just end of last week the share price of Deutsche Bank recorded a sudden fall of 15% and German Chancellor had to give a pep talk about the financial stability of Deutsche Bank. At one point of time last week, UBS lost 9.35%, Deutsche Bank 10.17%, Barclays PLC 9.08% and HSBC Holding 5.89%, all at the same time. The pain in the banking system of EU is far from over.

UBS agreed to take over Credit Suisse for almost $3.2 billion, and also to assume up to $5.4 billion in losses, to prevent further turmoil in the global banking system. Government of Switzerland also gave some contingent guarantees.

The AT1 Bond write off

However the 17 billion USD write off of AT1 bond seems to be at core of the turmoil. Besides adverse effect on the credit default swap rates also played a role. The AT1 market in Europe is variously estimated to be worth 275 billion USD and the Credit Suisse write-down of 17 billion USD is the biggest blow to this market. Before this, In 2017, 1.44 billion-USD worth AT1 bonds were written down in Spain when Banco Popular was taken over by Banco Santander for just one Euro to avoid collapse. Shareholders also lost 100% of their equity. Since banks are having cross holdings and they scratch each-others back, the break up of this AT1 Bond market needs more clarity.

Indian situation

In India, Yes Bank decided to write-off AT1 bonds worth around Rs 8,400 crore ( about 1.3 billion USD) as part of its restructuring plan. But that decision was struck down by the Bombay High Court, and a challenge regarding the same is still pending in the Supreme Court.

The Credit Suisse write-down of 17 billion USD AT1 bonds will also be challenged at the Court, because the order of seniority of stake holders has been jeopardized. If the AT1 bond holders get nothing, the shareholders of Credit Suisse should also not get any thing, as happened in the case of Banco Popular of Spain mentioned above.

Suggestion of European Central Bank (ECB)

In the meantime, ECB has come up with a suggestion that allowing only profitable banks to pay coupons on AT1 Bonds (interest) could be a way out. This could make these instruments riskier than equity. Already the actions in Credit Suisse and UBS merger has made AT1 bonds, riskier than equity, which it should not be, and the proposal of ECB will be a death nail to the AT1 market. Therefore, the financial institutions directly or indirectly holding AT1 Bonds will feel the heat in the stock market.

Effects of US sanctions

The unending nature of US sanctions have also affected the health of European banks, who have not been able to attract global deposits as much as they could have if they were not to follow US sanctions. Even now Swiss banking giants Credit Suisse and UBS are on a list of banks under scrutiny by the US Department of Justice (DOJ) for allegedly helping Russian businessmen to evade sanctions. The Swiss banks, along with a number of American banking majors, were reportedly subpoenaed by the US Department of Justice (DOJ) very recently. The probe is aimed at identifying which bankers and their advisers dealt with sanctioned clients and how those clients were vetted over the past several years. Even the?banks’ employees may subsequently be subject to further inquiries to determine whether they broke any laws. The lenders could face serious penalties for violating US sanctions.

?In 2014, French international banking group BNP Paribas was forced to pay around $9 billion after pleading guilty to Washington’s charges of allowing transactions involving sanctioned entities in Sudan, Iran and Cuba. Standard Chartered Bank in 2019 agreed to pay over $1 billion to settle a DOJ investigation over the violation of anti-Iranian sanctions.

Last month, Credit Suisse, said it had blocked over $19 billion in Russian assets as part of sanctions imposed on Moscow. This has raised a big fear in the mind of Chinese and Indian depositors (may be some deposits were made from clandestine sources) who can have an exodus from Swiss banking system.

If 100% US Government Guarantee on deposits comes into place

Unthinkable as of now, but if US Government provide 100% Guarantee to all deposits in banks what can follow ?

a.??????The deposits to some extent assume the nature of US Government Bonds which are also fully guaranteed by Government of USA.

b.??????The US government by inducement. incentive or legal force, can convert some of the very large deposits into bonds of various maturity.

c.??????US had in the era of gold standard (1930) seized the gold of private citizens, ?which ?enabled the government to print more dollars to try to stimulate the economy, and also to buy more dollars on the international markets to shore up the exchange rate. So compulsory conversion of high value deposits into government bonds by brute legal force cannot be ruled out.

d.??????If the US government gives 100% guarantee to bank deposits, the governments of Western economic system (where currency is convertible on capital account) will also be forced to follow the same 100% guarantee or some thing similar. Otherwise, there will be flight of capital from those countries to USA.

e.??????If all the deposits are guaranteed by the US Government, US Banks will be more reckless in lending unless some statutory checks and balances are introduced in the form of law and rigorous inspections are introduced.

f.???????This will be the end of capitalism in the current form. ?

g.??????The stock market of countries like India and China will also be affected, because foreign capital will flow out from risky stock investment to present high interest deposits ( government guaranteed ) and bonds in USA.

h.??????Indian Government will also be forced to increase the level of deposit insurance two folds or so. It may be noted that rupee is not yet convertible in capital account, so resident Indian retail depositors have only limited choice to put deposit in US banks in normal course, even if 100% guaranteed.

i.????????Flow of Non-resident funds into India may be slowed.

What about the numbers?

Broadly speaking the total bank deposit in USA is about 17 trillion dollars. The US government debt is about 31 trillion dollars. If 100% guaranteed bank deposits and bonds are added together that is about 48 trillion dollars. GDP of USA is 24 trillion dollars. So these two guaranteed debts is about 200% of US GDP. But these figures do not include pension liabilities, insurance guarantees and other kinds of guarantees provided by the US Government. If all those are added the figures will be mind boggling. Whether US government will be able to withstand such big burden of guarantee is the moot question. On top of this US private sector debt is about 222% of GDP.