European Deposit Insurance Scheme: Necessity, or will the North bail out the South again?

Lennart Vos, Nick Finson

December 2017

The current situation of the BU

The introduction of the BU has already been a great step forward. After the crisis there seemed to be a lack of harmonization between the institutions and regulations protecting the depositors. It was very clear that a lot had to change in the economic policy making of today. In order to “put an end to the era of massive bailouts paid by taxpayers and help restore financial stability” [1], the EU came up with the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). This new approach has changed the way in which crises are managed; rather than waiting for moments of insolvency, the main focus is on prevention and resolution. A safety net for all member states has been constructed.

However not all aspects of the plan have been put in place yet. For the BU to work as good in practice as it does on paper more grounds have to be covered. It is of vital importance for the EU that liquidity can flow freely in order to ensure stability in the banking system. To ensure that that ‘bank runs’ as the ones seen in Greece belong to the past, the EU developed regulation for Deposit Guarantee Schemes (DGS). The most important feature of DGS is the building and maintaining of depositors’ trust. Banks are the first institutions that are responsible to ensure this trust. There are however circumstances where banks have insufficient possibilities to maintain this trust. For these situations a DGS is established. Though there already exists a regulatory framework for deposit insurance schemes, the establishment of a European Deposit Insurance Scheme (EDIS) is of the uttermost importance to break the sovereign-bank nexus and to decrease spillovers in times of crisis. As can be seen in figure 1, EDIS would complement the third pillar of the BU

Source: Working document on European Deposit Insurance Scheme, Committee on Economic and Monetary Affairs, 16.6.2016.

Current Deposit Guarantee System

At this moment, deposit insurance schemes are developed on a national level. As part of the realization of the European Monetary Union (EMU), the European Commission (EC) created the first directive concerning Deposit Guarantee System (DGS) for each member state in 1994 [2]. Several member states increased the coverage of the DGS in order to increase bank trust and to prevent future bank runs from happening after the start of the financial crisis. Ireland for example unilaterally introduced an unlimited DGS, which led many depositors from British banks to shift their money to the Irish counterparts [3]. Although the intentions of the Irish government were to create stability and bring back trust in the financial system, it created an unfair playing field leaving British banks with genuine liquidity problems.

To overcome this problem the EC came with a new directive in 2014 [4], henceforth referred to as ‘Directive’, which harmonized the different guarantee schemes in the EU. The main underlying principle of this new directive is the creation of similar levels of confidence between banking institutions in the EU, which in turn wipes out competitiveness disturbing the trust equilibrium [5]. It is however still a directive that tries to regulate the DGS on a sovereign level, not on a European level. This lack of European supervision is detrimental to the effectiveness of the current DGS for several reasons.

Deficits in the DGS: size, consistency and sovereign-bank nexus

Each member state is in the current Directive responsible for its own deposits guarantee scheme. In other words, there is no pooling of resources among the member states [6]. The only mutual dependence lies in the possibility for a DGS to (voluntary) engage in mutual lending in case a DGS is in need of financial means [7]. There are three main flaws in this framework of national DGS that can be eliminated by the establishment of EDIS.

Under article 10 of the Directive it is stated that the funding of the DGS is ensured by the member states, implying a fiscal backstop with the governments acting as lenders of last resort [8]. The first deficit in the Directive is therefore that the credibility of the national DGS is in large part determined by the creditworthiness of the sovereign [9]. The strive towards a harmonization of the BU and the DGS is countered by the effects of the sovereign-bank nexus that is still in place. If a sovereign experiences financial difficulties, which is not unlikely given the current state of debt of some member states, the DGS of the concerning sovereign will also immediately be less trustworthy creating a so-called doom-loop.

Germany heavily opposes a single European deposit fund since they see this kind of risk sharing as a step towards the sharing of debt [10]. This would bring a relative high burden on German taxpayers and fears will grow that they end up paying for failures in other countries. Another argument heard a lot from antagonists is the moral hazard EDIS would cause. Sovereigns and banks might feel less pressure to reduce the existing risks. Financially weak countries such as Italy and Portugal should therefore first get rid of their bad loans. It is however illogical to think that a sovereign would have a lower incentive to prevent bank failures from happening given there are still uninsured deposits. The superordinate purpose of EDIS is the solidification of consumer trust, as this is the underpinning of the whole economical system.

The second deficit of the current DGS is the lack of an answer for differences in the size of the member states. Smaller countries within the Eurozone face the riskthat when a single national bank has to draw upon the DGS, all other banks in the country have to contribute to the refilling of the DGS. Not only will this saddle banks with a higher financial burden, most likely taxpayers in this country will have to pay the bill [11].

Wolfgang Schäuble, the former German minister of finance, argued in 2015 that it is necessary to first revisit regulation before entering in new insurance schemes [12]. He stated that a revision of shareholder rights in case of government or bank defaults must be prioritized. He does however not realize that this would relentlessly undermine the goal of the BU to create and maintain trust and stability. This measure as proposed by Schäuble would merely be a dummy since the defaults of banks are already prevented by the SRM. Germany however is not willing to give in on this topic, even threatening to come up with legal action if their protests remain unheard [13].

The third deficit in the Directive lies within the inconsistency of the Directive with other BU resolutions such as the SRM and SSM. These mechanisms are controlled and regulated on a European level. If supervision has proven to be inadequate on a European level and banks are getting into financial trouble, how would it be fair that a national DGS has to overcome these problems?

The chief economists of the German ministry of Finance, Ludger Schuknecht, wrote in an article that there is no need for EDIS since there already is an extensive framework of risk sharing schemes as well as other safety nets [14]. As a result of these well-constructed regulatory and supervisory mechanisms there is no need for an EDIS he argues. The main oversight in this line of reasoning is the doom-loop that still exists between the sovereign and the bank as we have already mentioned earlier in the article. Although both the European Central Bank and the IMF [15] urge for EDIS, Schuknecht seems to neglect the necessity for it.

How to proceed?

An effective establishment of EDIS is of great importance for the future of the BU. The EC already made plans to start with the implementation of EDIS. As shown in figure 2, EDIS would gradually replace the current national DGS and be fully working in 2024. It is a shame that there is a delay in the introduction because of political resistance. When the EDIS would be fully operational the EU would be endowed with a much more resilient and credible financial system. In such a system depositors and taxpayers are better protected but most importantly the sovereign-bank nexus would deplete. Countries that bear a lot of banking risk at this moment should put ingenuine effort to improve the quality of their banking system and reduce the risks. Not only would this be beneficiary for their own resilience, it would mean a rapid acceleration of negotiations on EDIS.

Source: finance-watch.org

Footnotes

[1] Commission, Banking Union: Restoring financial stability in the Eurozone, 15 Apr. 2014 (2014 Commission BU Memo) p.2.
[2] Boccuzzi 2016; Baglioni 2016.
[3] Baglioni 2016
[4] Directive 2014/49/EU
[5] Stuchlik, A., 2016, EU legislation in process. European Parliament Research Service. 14 March 2016
[6] Baglioni 2016
[7] Article 12 Directive 2014/49/EU
[8] Article 10 Directive 2014/49/EU; Baglioni, 2016.
[9] Knot, K., Lecture Vrije Universiteit Amsterdam 24 November 2017; Baglioni, 2016.
[10] Quaglia 2017
[11] Baglioni 2016
[12] https://www.ft.com/content/df1cf84a-57be-11e5-a28b-50226830d644
[13] https://www.ft.com/content/76a651b8-9db8-11e5-b45d-4812f209f861
[14] http://blogs.faz.net/fazit/2016/02/08/an-insurance-scheme-that-only-ensuresproblems-7298/
[15] https://www.imf.org/external/pubs/ft/sdn/2013/sdn1301.pdf

References

  • Baglioni, A. (2016). The European Banking Union: A Critical Assessment. Palgrave Macmillan studies in Banking and Financial Institutions.
  • Boccuzi, G. (2016). The European Union: Supervision and Resolution. Palgrave Macmillan studies in Banking and Financial Institutions.Elliott, D.J. (2012). Key Issues on European Banking Union Trade-offs an Some Recomendations. Global Economy and Development.
  • Moloney, N. (2014). European Banking Union: assessing its risks and resilience. Common Market Law Review, 51 (6). pp. 1609-1670.
  • Gordon, J.N. and Ringe, W. (2015). Bank Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take. Columbia Law Review, 115. pp. 1297-1368.
  • Quaglia, L. (2017). The politics of an asymmetric Banking Union. Robert Schuman Centre for Advanced Studies.

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Lennart Vos

MSc Finance at VU Amsterdam

Nick Finson

MSc Finance at VU Amsterdam