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From Forbes contributor Tim Worstall-

"Think through why we have deposit insurance? Banks, simply because of fractional reserve lending, are vulnerable to bank runs. If all the depositors turn up at the same time looking for their money back they cannot have it: it’s out in the loans to businesses and mortgages to consumers. This is a known fragility of the system. The only possible solutions are either to have full reserve banking (a bad idea for other reasons) or to have deposit insurance. In that insurance the government stops bank runs stone dead. By promising that depositors (up to some level) cannot lose money. Thus a run does not form and become self-fulfilling.

The point isn’t to make the depositors whole: it’s to stop a bank run forming in the first place. But, what if the government then reneges on a promise to insure depositors? Then the insurance isn’t going to stop bank runs, is it?

How important this is will clearly depend on how many people take note of it. Imagine that, say, the Italian banking system gets into trouble. If we all knew, or all depositors in Italian banks knew, that deposit insurance was inviolable then there might be a way to deal with a troubled Italian banking system. But if word gets around that, whatever people have actually said, deposit insurance isn’t inviolable, that if there are serious problems then government will not live up to their promises (or perhaps, that the EU will not allow them to do so) then what use is the insurance in stopping bank runs? Why won’t all the money flee to Germany thus creating that very bank run everyone is trying to avoid?

Perhaps I am over-emphasising this. But it looks like an extremely dangerous decision for the future to me. Even when Iceland and all its banks went bankrupt the Icelandic government did keep its promises under the deposit insurance scheme that it had. And breaching that principle just seems to be obviating the whole point of having deposit insurance in the first place.

I certainly wouldn’t want to be a central banker trying to deal with a banking liquidity crisis now that it’s been shown that government promises aren’t worth the paper they’re written on, that’s for sure.

It really does strike me as an extraordinary decision, one that will have unpredictable long-term effects."

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