The Fallacy Of State-Backed Deposits

| About: CurrencyShares Euro (FXE)
This article is now exclusive for PRO subscribers.

There is a perception in Europe during the current crisis that Germany should somehow guarantee all deposits, similar to what is done in the U.S. with the FDIC.

The big difference between the eurozone and the United States is the U.S. is one country with one currency, and the eurozone is many countries with one currency. The only primary source of emission of money is a central bank, because it has the sole ability to create money. Europe keeps central banks by state, but as these central banks do not issue currency, they mostly serve as policy advisors. In reality, without a currency, a central bank has little purpose.

The only functioning central bank in the eurozone is the ECB. The ECB is really the only institution capable of offering deposit insurance to any bank operating in euros, because the ECB is the sole institution capable of creating euros. While German banks may be "solid," if they did have a run on their deposits they would be left to turn only to the ECB.


As a comparison, let's look at how the FDIC works. The FDIC is a corporation that insures deposits in its member banks, now up to $250,000 per deposit. Insurance fees are paid by member banks, which finance a reserve fund that is used in the event of a bank failure. During normal times, this works OK, as the number of failed banks is quite limited -- even during the S&L crisis.

After the credit crisis in 2008, the FDIC fund became negative for the first time. However, the FDIC can always turn to the Fed, as a "lender of last resort."

This suggests the FDIC is really only working when there is no crisis. During economic booms there are still occasional bank failures, frauds, and other situations where the FDIC may step in. However, when there is a crisis of large proportions, such as what we experienced in 2008, the FDIC simply does not have enough funds generated by member fees to cover the amount of deposits.

Another thing to consider is that most of the credit crisis of 2008 losses were borne by investment banks, mortgage banks, and other institutions not members of the FDIC. Some retail banks did engage in mortgages, as the mortgage market expanded rapidly during the real estate boom. However, as depositors and lenders, retail commercial banks were largely unaffected. The mistake on their part, of course, was mixing the two businesses, trying to use the Lehman "financial supermarket" model, causing subprime loan losses to affect the entire bank.

The point here is that we have not seen a large retail commercial bank failure, such as a Bank of America (NYSE:BAC). According to FDIC data, as of June 2011 (the latest available data), Bank of America has $948 billion in deposits. If a retail commercial bank of that size failed, where would the funds come from? Certainly not the FDIC.

Since the "supposed" TARP relief from Congress, independent analysis indicated that the Fed had spent anywhere between $7.7 trillion and $24 trillion bailing out banks. The Fed stated it was "only $1.5 trillion," but that's still at least twice as large as the TARP package authorized by Congress.

It is reassuring to know that when things get dicey, the Fed is there with support. However, it severely reduces the apparent role of the FDIC in a systemic crisis.


The significant structural difference between the Fed and the ECB is that the Fed represents one country with one currency: the U.S. with the dollar. The ECB represents multiple countries with one currency, the euro. While everyone knows this, those who propose a German bailout must have missed the technicality that the German central bank does not have the authority to create euros -- this power lies only with the ECB. While the German government may lobby the ECB to do this, it is not their discretionary right to do so unilaterally.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.