Money manager Peter Schiff says, “Cyprus is a wake-up call for everybody who has a bank deposit. . . . When you are depositor, you are in fact . . . lending your money to the bank.” Schiff predicts, “There’s no question . . . banks will fail. The question is will government do the right thing and allow depositors to lose money. Or, do the wrong thing and bailout depositors by printing a bunch of money which, in the long run, means deposits will lose even more value.” ….
Finally, banks raise money from depositors. Depositors get the lowest rate of interest, which is the tradeoff for having the strongest position in case of bankruptcy. In addition to not suffering any losses until all other classes of capital are zeroed out, depositors also enjoy a government guarantee today, at least up to a certain amount (€100,000 in the case of Cyprus)—so long as the government can pay. It is important to note that while the government maintains the fiction of a “fund” to cover such losses, in a bank crisis the losses are imposed on the taxpayers. Today in the US, for example, the FDIC has a tiny reserve to cover an enormous deposit base.
In the modern world, government bonds are the key security in the financial system. They are defined as the “risk free asset” by theory and regulatory practice. They are used as collateral for numerous other credit transactions. And banks hold them as core assets. Let’s focus on that. A bank borrows from depositors and buys a government bond (and not entirely by choice). There are two problems with this.