The Hypocrisy of the Deposit Insurance

The U.S is going through a banking crisis and pulling the rest of the world with her. Almost all of the emerging markets have gone through similar banking crises in the last 15 years. Each case differs on some dimensions, except for the important role played by the deposit insurance that lead to moral hazard. A structurally unsound banking system combined with implicit government bailouts lead to excessive risk taking. This has been emphasized numerous times by academics, politicians and the IMF. The cure for these unhealthy economies—as goes the advice from the IMF and other doctors in the developed world—lies in breaking this cycle. This, they claim, should be achieved by extensive structural banking reforms, where deposit insurance must be reduced sharply.

Now the developed world is experiencing a crisis initiated by the U.S. and one of the policy actions taken by many countries is exactly the opposite of what has been prescribed: increase the amount of  insurance to the extent that all the deposits must be temporarily under guarantee. How can this be? Well, after all, we are trying to prevent the collapse of the worldwide credit system, so these actions are justified.  In contrast, the emerging markets have been advised to let failing banks go, no matter how big and important they are for their financial system.

“Preventing the collapse of global financial system” sure sounds much better than “hypocrisy.”

Nobody would have cared about the hypocrisy if the emerging markets were doing better now. Unfortunately this is not the case. The emerging market currencies all have depreciated against the major currencies because now they are relatively more “risky.” Their banks have much lower amounts of deposits under guarantee relative to the U.S.  The stars of the carry trade, Turkish TL and Brazil Real, lost 20-30% of their value in the last couple weeks. In the past, the financial crises in emerging markets almost always combined with currency crises. But now we are witnessing an appreciating dollar in the crisis country. This is not so surprising, because the emerging markets are relatively less “safe” now, and more likely to be subject to bank runs. And the dollar is the reserve currency after all. I, and many friends who live in the U.S., just have transferred our funds that are above the guaranteed limits, out of Turkey, into the U.S., in spite of the recent press conference of the ministry of finance, who promised to pass a new law to keep the funds of Turkish expatriates inside Turkey. The irony here is that we did exactly the same during the 2000-2001 crisis of Turkey, when locals and foreigners were both fleeing the crisis hit emerging markets.

Now here is the dilemma: in order to prevent the domestic banking crisis, emerging markets central banks would like to lower interest rates. But this will only exacerbate the depreciations they are experiencing. Consider the specific case of Turkey, and keep in mind that Turkey is an inflation targeter with a high degree of exchange rate pass through. In a recent conversation (3 weeks ago) with a Central Bank of Turkey (CBT) official, I was told that they were not planning on changing the interest rate, similar to most European countries. The official suggested that rates might even go up if the loss in TL is big enough. In fact Denmark just increased the rates in spite of the fact that they are one of the strongest economies in Europe, just because they had to maintain their desired parity with Euro. In its September 29 press release, the CBT stated that “current circumstances require monetary policy to be flexible on both sides. Depending on the impact of the ongoing financial turmoil on the domestic economy, the committee will consider measured rate cuts as well as temporary tightening through active liquidity management.” In its October 10 press release it reads: “It has been decided that the Central Bank should resume its activities as an intermediary in the foreign exchange deposit markets as of today, until the uncertainties are eliminated in the international markets.”

“Flexibility” sounds much better than “dilemma…”

I wonder what will the advice for the next emerging market crisis be? : Let the failing banks go; do not worry, markets will correct themselves, or will it be: Save them all like we did in 2008? I guess we all wait and see…