Tuesday, March 19, 2013

Planning for a Cyprus Syndrome

"You're thinking of this place all wrong--as if I had the money back in the safe. The money's not here."
--George Bailey (It's a Wonderful Life)

What would you do if you perceived the threat of a Cyprus style depositor haircut to be significant in your locale? "Simple," you say, "I'll just empty my bank account ahead of the threat."

Make sure that you understand how modern banking works before you get too comfortable with that plan.

Suppose you deposit $1000 at a conventional bank. Even today, many people assume that the money goes into the vault and that your $1000 can be withdrawn on demand.

In the early days of banking this was true. Banks were simply  'money warehouses' with the core competence of keeping property secure. Depositors paid banks fees for doing so.

However, it didn't take bankers long to learn that they could make more money by lending some of the money that they were holding for others. As long as good credit risks were identified and depositors didn't all rush to withdraw their deposits at the same time, this could be a lucrative business model.

Bankers also soon learned that they could use depositor funds as collateral to borrow from other lenders and trade financial securities for their own accounts.

Deposits were no longer just liabilities; they became assets.

And banks became leveraged. To the depositor, this leverage means that all deposits are not available for withdrawal on demand. Only a fraction of the money is in the vault; the remainder is essentially loaned out to others (those 'others' could include the bank itself). The fraction of funds available to depositors depends on the bank's reserve ratio.

Suppose that your bank has a 10% reserve ratio. On average, only $100 of your initial $1000 deposit would be available. To get more than that, you'll have to beat most other depositors to the window.

In the 10% reserve ratio situation, then you'll have to been in the fastest 10%. This is a best case scenario, however, as it is likely that the distribution of deposits is skewed--meaning that a couple of large depositors who reach the window ahead of you could clean out the vault all at once.

Moreover, most banks are operating at effective reserve ratios well below 10%--meaning that less than $100 of your original $1000 is available on average.

The bottom line is that if you have money in a bank and you plan to manage risk of a Cyprus Syndrome by withdrawing your funds before the onset of crisis, then you better be fast.

Or you better have a Plan B.

1 comment:

dgeorge12358 said...

Frank Capra first produced the 'run on the bank scene' in American Madness in 1932, then later in A Wonderful Life in 1946.