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How not to restore confidence in eurozone banks

The insolvent Spanish banking system is being bled dry by depositor outflows. Spain has asked and the the EU has agreed to recapitalize its banks in order to enable the ECB to keep lending against the run. There is debate concerning the need for a eurozone deposit guarantee to restore confidence and end the runs on the peripheral banks. Depositors in the peripheral countries face the risk of individual bank failure as well as the risk of a forced redenomination into domestic currency.

Because banks are highly levered, inherently illiquid, and analytically opaque, depositor confidence can only be maintained by the expectation of both a lender of last resort as well as a state rescue authority. Such mechanisms are the reason why banks never default on their deposits and are instead rescued (bailed out). Throughout the entire financial crisis of 2007-12, no eurozone bank, no matter how tiny, has defaulted upon its deposits.

The state mechanisms that backstop depositor confidence depend upon the willingness and the ability of the state to rescue banks. This has now been called into question in the eurozone because a number of states lack the resources required to maintain systemic solvency, which the ECB requires as a precondition for lending. That problem is most acute in Spain at the moment, hence the hastily-agreed EUR 100 billion bailout.

Governments rarely offer blanket deposit guarantees, but they are understood to exist implicitly. Because regulators want investors to provide a degree of market discipline, such as credit ratings and other measures of solvency, they create sufficient constructive ambiguity around bailouts for markets to punish weaker banks. This requires a dance between depositor discipline, on the one hand, and market confidence on the other. No regulator can realistically expect the retail depositor to add bank analysis to her other daily responsibilities.