[bulgaria bank run]REUTERS/Stoyan Nenov The Italian banking crisis has moved to its next inevitable stage. European institutions can’t find an answer as to whether and how to protect deposits in Italian banks. So Italy adopted new EU-mandated policies regarding bail-ins in January. The rules for these bail-ins require a bank’s shareholders and debt holders to absorb losses before taxpayer money can be used to assist a bank. European deposit guarantees protect deposits of less than 100,000 euros. Deposits of more than 100,000 euros, however, are at risk. As a result, individuals and small businesses that hold what they believe to be relatively low-risk investments are actually put in danger. As Italy grapples with the new policies, there is a dispute within the eurozone over who should take responsibility for deposits protected under European laws. This is a familiar scenario: the EU once again discovers its original dictum would lead to disaster. So it changes its course to find a solution that is acceptable to all members. In other words, we are now at the point of paralysis. But this time it is paralysis over an issue with catastrophic implications. A RELIABLE BANKING SYSTEM IS CRITICAL TO THE SOCIAL ORDER We can make a distinction between investments and putting money in the bank. Investments come with both opportunities and risks. Holding money in the bank shouldn’t carry either. The benefit of having an individual bank account is to safeguard money. If banks cannot guarantee this safety, then there is little point in putting money in a bank in the first place. In fact, withdrawing funds from an unsound bank becomes a matter of urgency. If enough depositors become uneasy and withdraw their money, the last man to the door may be wiped out. For the middle class, insecurity in banks is an existential crisis. Wealthy individuals and corporations have experience in managing risks. They diversify not only among banks, but among countries or among asset classes. They can be hurt, but rarely completely devastated. Although the middle class may have money in more than one bank, most risk-management tools are both out of their reach and outside their experience. [Gold bars]REUTERS/Stoyan NenovFor the middle class in Euro-American culture, banks are a secure place to store their lifetime assets. Once they are seen as insecure, various ploys emerge. People buy homes, gold, foreign currencies, or try, to get the money out of the country. When this occurs on a massive scale, the result is a contraction of lending by banks, bank failure, and depression. But the most important result is the loss of confidence in social and political institutions by the middle class. We are seeing this happen now in some export-oriented countries and some European states. There is a social contract between the middle class and society as a whole. The middle class agrees to work hard and save their money. In return public institutions guarantee that the fruits of their labor will be secure. If they were to lose their deposits, it would be a financial catastrophe. But the violation of the implicit social contract would also lead to political catastrophe. This is why US President Franklin D. Roosevelt, in his first fireside chat, focused on the need to restore confidence in institutions such as banks. Stripping the middle class of their assets—or making them afraid this might happen—leads to massive political unrest. PUBLIC’S CONFIDENCE IN BANKS IS ERODING IN EURASIA The fear of deposit losses is stalking countries besides Italy. Exporters across the globe experience reduced revenues, and the European Union’s financial troubles continue. Meanwhile, governments in Eurasia are increasingly worried about the public’s confidence in their banking systems. Reduced confidence would not only have immediate financial consequences, but could also have far-reaching geopolitical implications. After all, the perceived ability of governments to manage growing crises diminishes. Deposit insurance is at the core of government efforts to maintain confidence in banking systems. Deposit guarantees pledge each deposit holder to safeguard part of their assets. That’s what sets them apart from other government tools for stabilizing financial systems [The Federal Deposit Insurance Corp (FDIC) logo is seen at the FDIC headquarters as Chairman Sheila Bair announces the bank and thrift industry earnings for the fourth quarter 2010, in Washington, February 23, 2011. REUTERS/Jason Reed]REUTERS/Stoyan NenovThe massive crisis that the US financial system faced in the early 1930s led to the creation of the Federal Deposit Insurance Corporation (FDIC). FDIC protects deposits of insured banks or savings associations and can insure up to $250,000 in deposits for individuals. Deposit insurance schemes around the globe differ in their design and coverage, but fundamentally they are configured to maintain public confidence in the system. Both the economic crisis facing exporters and the eurozone’s ongoing financial difficulties are increasing the significance of deposit insurance. For example, deteriorating economic conditions in Azerbaijan have already led to protests throughout the country. Azerbaijan’s government recently announced that the country’s central bank may assist the Azerbaijan Deposit Insurance Fund (ADIF) if it is unable to compensate depositors. This statement came after the central bank revoked licenses of six Azerbaijani banks and was intended to reduce fears of closure. The central bank’s intervention signals the regime’s insecurity about public confidence in the banking sector. Distrust of the banking system would lead to a run on the banks, significant disruptions to the country’s financial system, and an erosion of the regime’s position. Russia is also concerned about the public’s confidence levels. Low oil prices and sanctions hit hard Russia’s economy (particularly its currency). It is no surprise that the Russian government boosted guarantees for bank deposits in December 2014. The Kremlin allocated extra funds to the country’s Deposit Insurance Agency (DIA) and increased the deposit insurance coverage limit for individuals to 1.4 million rubles (the equivalent of about $18,300 under the current exchange rate). Russia’s DIA is a busy entity: over the past two and a half years, the country’s central bank has shut down over 150 banks, with many others under crisis watch. In fact, Russia's Finance Ministry recently announced that it is considering requiring bail-ins of large depositors. While the move is intended to help protect the overall stability of the system, it shows that the ministry expects more significant bank bankruptcies. Reduced energy revenues have escalated Russia’s economic problems. As a result, the importance of deposit insurance as a tool for maintaining public confidence and limiting social unrest will grow. [A man walks past the headquarters of the People's Bank of China (PBOC), the central bank, in Beijing November 20, 2013. REUTERS/Jason Lee]REUTERS/Stoyan NenovConcerns over internal stability also played a role in China’s decision (in May 2015) to introduce deposit insurance for the country’s banking system. The government generally steps in to assist banks and investors and implicitly guarantees deposits, especially at bigger banks. Large bank failures, therefore, are mostly unheard of in China. Politically, Chinese decision-makers feel that they cannot allow banks to fail. Such a move would further undermine confidence in the leadership and China’s economic system as a whole. Nevertheless, the Chinese government recognized that guarantees are also failing to discourage banks and investors from making risky choices. China’s decision to introduce deposit insurance, therefore, was designed in part to highlight the limits of government assistance and to encourage better investment decisions. While China differs greatly from its Western counterparts, the Chinese leadership also aims to use deposit insurance to boost confidence and stability in its banking sector. AN UNCERTAIN FUTURE FOR EUROPEAN DEPOSITS In Europe, as in the US, deposit guarantees have become a part of the social contract between the people and the authorities. But the question is which authorities are ultimately responsible for guaranteeing the deposits. The future of deposit guarantees is one of the disagreements between Germany and the eurozone’s other members. There are EU-wide regulations on deposit insurance, but those are currently implemented on a national level. In November 2015, the European Commission officially presented its proposal for a European Deposit Insurance Scheme (EDIS). Under the plan, a European fund would be created, financed directly by bank contributions, and adjusted for risk. At first, the European fund would only be used if national-level deposit insurance funds exhausted their resources. Over time it would take on a greater role and fully insure all national deposit guarantees by 2014. [Mario Draghi]REUTERS/Stoyan NenovGermany opposes the scheme and argues that risk within the eurozone has to be reduced before such a risk-sharing plan could be viable. Fundamentally, the EDIS would represent a financial obligation for Berlin to assist eurozone countries with troubled financial systems. Countries such as Italy support the plan because it would provide a much stronger layer of security for depositors than national-level insurance schemes. Deposit insurance is thus one of the elements of Germany’s geopolitical dilemma: on one hand, Berlin wants to safeguard the stability of the eurozone, but on the other hand, it would like to minimize its own financial contributions to other eurozone countries. We saw a similar drama in Cyprus in 2013. Cypriot banks failed, and the Europeans (led by the Germans) refused to bail them out. The result was that banks were closed for several days and parts of deposits exceeding 100,000 euros were seized. The Germans argued that Russian money launderers used the Cypriot banks, and they deserved to fail because of imprudence and corruption. However, the Cypriot banks held deposits for entities that contributed significantly to the economy. Those included the hotels at the center of the tourism industry and British retirees who had saved a few hundred thousand euros in a lifetime of work and retired to Cyprus. The latter were devastated. The former could not pay their employees for weeks, and many never recovered from the crisis. What had been an uncertain proposition—putting their money in a bank in Cyprus—became a suicidal position. Cyprus has still not recovered. Now Italy (which represents about 11% of the EU’s GDP) also finds itself in a banking crisis. Its banks are linked to all of Europe’s banks that have bought Italian paper. It is possible for the Italian government alone to bail out the banks. But Italy does not own the printing press that can help monetize the banks—it belongs to the European Central Bank (ECB). The political reality is that the Germans heavily influence the ECB. In other words, the Germans control the monetary supply, but they intend to push the responsibility of this banking problem to the Italians. This could lead to a crisis similar to the one experienced in Greece… but on a much larger scale. Essentially the Germans are demanding that. If Italian banks fail, a form of the Cyprus solution will be implemented in Italy. The potential consequences for the European financial system are hard to calculate. German Chancellor Angela Merkel, however, is still busy reassessing her political position, which has eroded since the onset of the refugee crisis. [RUSSIA'S CENTRAL BANK GOVERNOR ELVIRA NABIULLINA APPLAUDS DURING THE VTB CAPITAL ]REUTERS/STOYAN NENOVCATASTROPHIC IMPLICATIONS The international dimension of the banking system is also at a critical stage. As the exporters’ crises deepen, the ability to maintain comprehensive deposit guarantee schemes is key for countries like Azerbaijan and Russia. Two factors to watch are deposit levels and capital flight. Russia has struggled with high levels of capital flight. Further outflows could indicate that efforts to promote confidence in the system are failing. At the same time, negotiations over the future of the planned EDIS will be a key indicator for the stability of Southern European banking systems and the relationship between Germany and the rest of the eurozone. From Russia to China and the European Union, public confidence in banking systems is a factor that affects not only financial stability, but also the survival of regimes and political institutions. There is no international financial institution that can possibly deal with all these potential failures… and certainly none that can deal with the social consequences. When we look at Eurasia, we see banking problems that need to be solved. The solution has three layers: - First, to maintain a prudent banking system; - Second, to provide a reliable insurance system for deposits; - Third, to provide security for deposits through the government, which ultimately has the resources and an interest in political and social stability. But if prudence has already collapsed and if the insurance system is incapable of coping with the flood, only the third layer remains. However, if it is beyond the state’s will or capacity to act effectively, there will be hell to pay. SUBSCRIBE TO _THIS WEEK IN GEOPOLITICS_ George Friedman writes the free weekly column _This Week in Geopolitics _for Mauldin Economics. Subscribe now and get an in-depth view of the forces that will drive events and investors in the next year, decade, or even a century from now. NOW WATCH: Why women cheat — and what their husbands can do to prevent it
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