Who Do Depositors In Cyprus Trust?

Mar 24, 2013

By Dr. George Korenko

Last week, the legislature in Cyprus rejected a proposed one-time levy on bank deposits, including insured deposits, which was part of a bailout plan offered by European Union countries.  While this decision may have failed to alleviate Cyprus’ current economic uncertainty, it did provide an important lesson in the avoidance of unintended consequences.  Policies created without appropriate consideration of the economic incentives created are likely to have unexpected—and unintended—effects.  This principle applies not just to emergency macroeconomic policies such as the levy on bank deposits, but also to other areas that involve incentives, such as regulations and corporate policies.

A one-time levy could have the advantage of raising funds without affecting the future behavior of those taxed.  However, this only works if those being taxed actually believe that this is a one-time event.  When this is not the case (that is, a commitment made by a decision-maker today is not credible in the future) a problem known in economics as time inconsistency arises.  

The time inconsistency problem can be illustrated with a simple example. Consider the issues associated with oceanfront properties that are periodically devastated by hurricanes.  For public safety and to avoid the significant expenses associated with evacuating and then rebuilding these properties, the government could announce that it will not provide disaster relief or fund rebuilding after a storm.  However, if a storm comes and properties are destroyed, is the government’s threat to withhold aid credible?  It is reasonable to think that the answer is “no,” because the government is unlikely to turn a blind eye to victims of a natural disaster in need. If this is the case, the government’s incentive to threaten to withhold aid before the storm is not consistent with its incentive to provide relief after the storm.  Thus, the government cannot make a credible commitment to withhold aid from beachfront communities. 

The one-time levy against bank deposits suffers from a similar problem because the incentive to tax bank deposits now and promise never to do it again is likely not credible.  If the Cyprian government failed to resolve its economic woes with these funds (Greece, Cyprus’ struggling neighbor, has already had more than one bailout), in the future it could have had an incentive to apply the same type of levy.

As the oceanfront property example suggests, this issue is not new.  Indeed, one reason for the relative stability of the U.S. banking system is that depositors believe their funds are safe in banking institutions that have Federal Deposit Insurance Corporation or similar insurance.  It is important to keep in mind, however, that this does not mean the FDIC stands ready to repay all funds to depositors no matter how many banks are liquidated.  Rather, it means that it has enough funds to provide an orderly liquidation of failed banks and maintain depositors’ confidence in the banking system—as long as too many banks (or too many large banks) do not fail in quick succession (in which case, other government action may be prudent).

A fundamental problem with the rejected levy on Cyprian bank deposits is that it would likely have led to unintended consequences.  Depositors—even those with insured deposits—have a short-term incentive to take as much money out of the banks as possible to avoid the levy.  A consequence of this “run” on Cyprian banks could be their inability to fund withdrawals, exhaustion of the Central Bank of Cyprus’ Deposit Protection Scheme, and massive losses for depositors.  In addition, because of the “time inconsistency” problem, rational depositors are unlikely to believe that this is a one-time event.  Thus, confidence in Cyprian banks could be permanently eroded and the health of its financial system permanently impaired. 

These potential unintended consequences illustrate the dangers associated with solutions to problems that do not fully consider all the economic incentives these solutions create.

Experts

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