Sunday, October 12, 2008 0 comments ++[ CLICK TO COMMENT ]++

Can Governments Actually Afford to Back Their Banks?

One of the popular strategies these days is for governments to announce that they are backing the deposits in their country. I approve of the government strategy since we need to prevent bank runs that were the norm in the 1900's or earlier (or in modern day developing and undeveloped countries.) However, as investors and savers, the question is whether there is any merit to any of this. Can these governments actually back up their deposits?

The Economist examines this topic, and produces the following chart plotting debt and deposit as a percentage of GDP (as usual, click on chart for a bigger picture):



That chart looks scary. We can easily see how Iceland has little ability to do anything given the size of the exposure. I also remarked recently that Switzerland is another country that may face potential difficulties (I questioned whether a bullish bet on the Swiss Franc, as Jim Rogers seems to favour, is a smart bet.) Well, I never knew that Britain and Ireland were just a tad bit worse than Switzerland (using the measures on the chart.)

Overall, as the article makes clear, governments should be able to weather any problems given that investors tend to flee to government bonds during times of stress. Nevertheless, I would avoid potentially disastrous moves to capitalize on government promises. For example, there were stories early in the week of savers shifting their savings to Irish banks after Ireland promised to back the deposits (this was before other European governments followed suit.) Well, if there is one thing to be learned from the current crisis, it's that one shouldn't blindly chase yield. All those chasing Irish banks are taking extra risk for very little return. Just to be clear, I do not think Ireland or any other country is going to have difficulty backing their banks. But I just don't think it's worth betting money on that.

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