Banking union How to move toward European deposit insurance

A proposed scheme could stabilize the banking sector in the euro area – if legacy issues and false incentives are eliminated first, says German economist Isabel Schnabel.
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Europe is on the move: There are growing signs that serious reforms of the monetary union could be in the cards for 2018. But there is still one major sticking point: Germany is vehemently opposed to a common European deposit insurance scheme. This was actually intended to be the third pillar of the banking union. But unlike European banking supervision and a single resolution mechanism for bankrupt banks, it has not yet been implemented.

The basic idea of a common deposit insurance scheme is certainly correct. It is intended to give depositors throughout the euro area the certainty that they will get their money back even if their bank runs into difficulties. This is to prevent customers from withdrawing their money in a panic as soon as doubts arise about the solvency of their bank.

Deposit insurance schemes are currently financed at the national level by banks themselves, usually through risk-related premiums. This allows them to address smaller problems in the sector. But there are concerns that the accumulated funds would not be enough to cope with a major crisis.

Under the existing European rules, depositors are protected up to an amount of €100,000 per investor and bank. However, only 0.8 percent of those protected deposits are paid into the national guarantee funds. If those funds run out, the government can step in and guarantee the deposits – as it did in Germany in the fall of 2008. The actual security of deposits thus depends to a large extent on the solvency of the nation behind it, particularly in the event of a systemic crisis.

The incentives to shift national risks to the European level must be reduced.

Deposit insurance therefore creates a risk association between banks and governments. On the one hand, banks' problems can affect a country's solvency when its government steps in to support the banking sector. On the other hand, banks in a highly indebted country can be destabilized by the lack of credibility of its deposit insurance system. A key objective of the banking union is to sever this risk association between banks and states. A European deposit insurance scheme would contribute to this by absorbing the risks that a national deposit insurance scheme cannot bear.

But the reality is more complicated. Banks in some EU member states have higher levels of non-performing loans on their books. Their likelihood of failing is therefore much higher than elsewhere. Understandably, banks in other countries do not want to offer insurance against losses that have already occurred. Consequently, there can be no agreement on joint deposit insurance without a more resolute reduction of legacy liabilities. In addition, many banks hold high levels of domestic government bonds. This creates a danger that government-default risks will also be shifted to the European deposit insurance. Similarly, member states could even shift risks stemming from their economic policies– or a lack thereof – to the European level.

To win over Germany, these arguments must be taken into account. A group of 14 French and German economists, including myself, recently presented a report on the reform of the euro area, which contains such a proposal. First, it provides clear rules to reduce non-performing loans. Second, government bonds should no longer receive privileged status in banking regulation, reducing the concentration of risk in domestic government bonds. Banks are currently not required to support government bonds with equity capital. Third, the incentive to shift national risks to the European level must be reduced.

The idea of a "reinsurance model" arose against this background. It provides for "national chambers" in European deposit insurance, which are filled with contributions from national banks. Community liability only takes effect if these funds prove insufficient in a crisis. In addition, insurance premiums are to be structured in such a way that they take country-specific risks into account. In this way, the incentive problems described above can be substantially mitigated. Finally, a common fiscal backstop is to be created in order to cushion the impact of crises that would overtax a European deposit insurance system.

This joint deposit insurance system would effectively ease the risk association between banks and governments, increase financial stability and contribute to greater integration of the European banking market. Even the German saver could ultimately benefit from our proposal.

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