Guaranteed bank deposits and the market for lemons
One aspect of the Greek crisis which will affect many readers is the reduction in the amount of cash in a bank deposit which is protected. The Bank of England announced that the current guaranteed amount of £85,000 will be cut to £75,000 on 1 January. This has led to predictable outrage, with Andrew Tyrie MP, who chairs the Treasury Select Committee with distinction, being one of the leaders of the attacks.
The provision of any sort of bailout involving banks raises tricky questions. At the height of the financial crisis during 2008, the then Governor of the Bank of England, Mervyn King, agonised over the so-called moral hazard problem. Once you rescue a bank with state funding, the incentives to banks to ensure their own liquidity and solvency in the future might be weakened. King eventually decided that bailouts were essential. A strong consensus of economists agrees with this view, although there are prominent names who dissent.
Without the deposit guarantee scheme, bank customers would certainly have much stronger incentives to discover for themselves the creditworthiness of any particular bank. In general, the principle that the onus is on the consumer to find out about the risks of a purchase is widely accepted. Sellers cannot misrepresent their offer, but otherwise it is up to the buyer. This applies even to really big ticket items like houses.
The whole idea of protecting bank deposits, on this view of the world, is just another manifestation of the nanny state culture. People are grown ups and should take responsibility for their own actions. There is a lot to be said for this view in most cases. But the bank guarantees are different.
Way back in 1969, George Akerlof of Berkley published a paper for which he eventually received the Nobel Prize. It is called “The market for lemons”. He didn’t mean the actual fruit, but ‘lemon’ in the sense of a dud purchase. Akerlof illustrated his remarkably deep theoretical model with the example of the used car market. If you see a classified ad for a second hand car and go to look at it, you can kid yourself that you know what you are doing by kicking the tyres like Del Boy. But the plain fact is that the seller knows a lot more about the actual quality of the car than you do. Economists love jargon, and this simple concept became known as ‘asymmetric information’.
Markets themselves are often used to try to correct such imbalance. When you buy a house, you also buy the services of professionals like lawyers and solicitors. They supply you with the information needed to make you almost as knowledgeable as the buyer. Even they can’t tell you the dog next door barks at night. But with banks, dogs might bark all day and they are still very difficult for experts to hear. Regulators, central banks, finance ministries all missed the fact that in 2008 many banks were essentially bust. They all suffered from asymmetric information. Deposit guarantees are a Good Thing and should not be reduced.
As published in City AM on Wednesday 1st July 2015