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The recent losses incurred by depositors in Cyprus have led to an emerging consciousness among investors that their deposits are subject to a regime which is perhaps riskier than previously assumed.

The basic assumption commonly made is that a depositor retains full ownership of deposits placed at a bank. The legal position is actually subtly, but crucially, different. When one places a deposit with a bank, the relationship formed is that between debtor and creditor. It is not a relationship between somebody wishing to borrow space in a vault in which to place whatever object (such as money), and a person (such as a banker) willing to provide such a service. This difference in legal status is what initially gives rise to the risk of loss, since the repayment of the deposit becomes subject to the ability of bankers to remain solvent, which in turn is subject to their endless creativity being a net positive. A House of Lords ruling in 1848 explained the point well, and it is as relevant now as it was then:

Lost deposits are going to have systemic implications one way or the other

“The money placed in custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted, having received that money, to repay to the principal, when demanded, a sum equivalent to that paid into his hands.’’

However, anecdotal evidence suggests that the majority of people erroneously assume that they are the legal owner not of the debt which they are owed by the bank, but of the actual money placed in their account. One can sympathise that this is an easy error for depositors to make, especially if nobody disabuses them of it. It so happens that the existing financial system is fundamentally dependent on savers placing deposits at banks. For them to do so, they must feel that their money is “safe” – so one is unlikely to find the authorities offering investor awareness courses exploring possibilities to the contrary.

What is done instead is that a depositor compensation scheme (DCS) is set up which “guarantees” that a deposit will be repaid in the event of a bank failure. One could argue that it is the need for financial stability that is the primary driver, not the need to compensate depositors per se.

Note how a number of exceptions are made as to what is guaranteed. There are eligibility tests both for the depositor and the deposit. In the case of Cyprus, even those deposits which were eligible were at one point at risk of being lost via a “special” tax. That was a naked, and unwise, breach of the spirit of the DCS. It also served as salutary lesson as to the potential for cast iron guarantees to be dishonoured when political expediency takes centre stage. No EU exhortation – the more vocal the less convincing – that Cyprus was a special case is going to dispel the nagging doubt from now on.

What a DCS does not do is change the behaviour of either bankers or depositors. Any recourse to a DCS will in the final analysis be retrospectively (i.e. when it is too late) seen as a regulatory failure to ensure that (a) banks avoid wilful risk-taking, irrespective of the potential systemic implications and (b) depositors are shepherded away from banks which have business models which make them inherently more prone to fail. What is less clear is the merit of granting a banking licence, allowing it to raise local deposits, but simultaneously disqualifying those same deposits from recourse to the DCS. Systemic risk will not be eliminated simply by eliminating recourse to the DCS: It has to be eliminated itself. Lost deposits are going to have systemic implications one way or the other.

It is unrealistic to expect depositors to differentiate between banks based on their risk profile. In fact our own DCS is refreshingly candid about this aspect: “It (i.e. the DCS) draws its justification from the fact that many depositors are not generally in a position to make a comprehensive assessment of the risks affecting a licensed bank.” Quite so.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business.

Martin Webster is head of equity research at Curmi and Partners Ltd.