Tuesday, October 7, 2008

Guaranteeing Bank Deposits - Game Theory for the Europeans

The credit crunch has hit Europe with a vengeance. Whearas it used to be focused mainly in the US, it appears many European banks are now close to the brink. With some banks on the verge of bankruptcy or rapidly falling share prices, confidence in the banking system has evaporated. In this climate, savers became nervous and could start to withdraw their savings. The fear is of a new bank run which could undermine the banking system. At the moment, it is not so much private savers queuing up to withdraw their life savings, but financial institutions and corporate treasuries withdrawing short term deposits. This is causing serious liquidity problems.

If savers start withdrawing their cash, the banks are in trouble because they will not have sufficient liquidity to meet the demand for cash withdrawal.

One solution is for the government to explicitly guarantee all savings. (Currently the UK government guarantees the first £50,000 of savings).

The problem with the government guaranteeing all savings is that it could encourage irresponsible behaviour by banks who don’t have to worry because the government can clean up their mess. This is why the UK wants to avoid making an explicit guarantee for the £2 tillion worth of UK deposits. Yesterday, the chancellor Alistair Darling was rather vague in saying the Government will do:
Whatever is necessary to ensure stability of the financial system” – Without saying what this might involve.

The problem is that first Ireland and then Germany have made a guarantee to secure all bank deposits (in Germany it is just for private investors)
Therefore, if you are a nervous investor worried about your bank collapsing (and if share prices are anything to go by, things don’t look good at moment) you could switch your savings to Ireland or Germany. At least there, savings are guaranteed by government.
  • If people do switch to Ireland or Germany, which is a rational step to make, then the UK banking system will suffer.
  • Because Germany and Ireland have taken the step of guaranteeing savings, they will get an inflow of savings and countries which don't have a guarantee will suffer an outflow. This withdrawal of money makes the situation more difficult for the UK banking system.
  • This is why other countries such as Austria, Denmark, Greece and Sweden are indicating they will follow Germany’s example.
  • The best solution would have been to have a European wide response, Germany and Ireland have pursued a strategy which maximises their interests. But, this will probably lead to all countries having to follow suit. Therefore, the European banking system may end up being 100% guaranteed by the government, which may be a sub optimal solution in the long term.
  • Game Theory looks at the best response of an agent given response of others. The best outcome in game theory is when the players collude and agree on a coordinated outcome. When people pursue selfish ends they often make things worse for everyone, including themselves.
Unfortunately, in a financial crisis, the appeal of coordinated responses often disappears. It is why in the Great Depression, countries increased tariff protection. This tariff protection made the slump worse for everyone. But, people wanted to see some action and action, even if it didn't help.

It may be that, to secure confidence in the banking sector drastic action is needed. In a crisis the problem of moral hazard may be less important than protecting your banking system. Making explicit guarantees for savings may merely make explicit something that was long implicit.

One solution being muted is for the government to take a share in the major banks, in return for liquidity and higher guarantees.

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