25 May 2016

Bruegel: The European Deposit Insurance Scheme

Why is there a need for a European deposit insurance system? There are three basic arguments:

• The first one is about size. Insurances work better, the larger the number of banks included. Especially small countries will find it difficult to provide an effective insurance to its bank deposits. Certainly, if one bank in a small country is affected and needs a pay-out from the deposit insurance, this will have lasting costs on all the other banks’ deposits in the country as they would have to be charged more strongly to replenish the insurance fund. The cost of deposit insurance will become materially differentiated across countries after a one-time event in a small country in particular.
• The second is about consistency. One cannot keep a system in which supervision is centralised while deposit insurance is decentralised.Ultimately, such a system would mean that national deposit insurance and in extremis national tax-payers would have to stand ready to address problems that have arisen because of potentially inadequate European supervision.
• The third is about decoupling banks from sovereigns. The stated aim of banking union is to decouple banks from sovereigns. Since the ultimate backstop to deposit insurance is the tax payer and the government, the trust a deposit insurance provides will depend on the country in question. The quality of the sovereign will materially influence the trust in the banking system. Without a European deposit insurance system, the decoupling of banks from sovereigns will therefore be incomplete. [...]

Deposit insurance and crisis management.

There is a further important reason why European deposit insurance is advisable in monetary union: it is about the ability to manage sovereign crisis. The ESM is the main instrument to deal with sovereign debt crisis. Its treaty explicitly allows to bail-out only solvent countries. In case a country is not solvent, however, ESM resources cannot be provided to the country and at least conceptually a bail-in of sovereign bond holders is required. This gives rise to two difficulties: The first one is that is such a situation depositors are likely to panic and since they are in a monetary union they may move deposits to other countries. This, in turn, forces the ECB to provide large amounts of liquidity to the banks of the concerned country. And while central banks should provide liquidity to solvent but illiquid banks, it still increases the exposure of the central bank to banks concentrated in one country. A European deposit insurance, by creating trust, will likely minimize national bank runs and thereby also reduce central bank exposure. The second problem is the concentration of sovereign debt in banks of the same country. This renders a bail-in more difficult as the banking system will be much more affected than if the sovereign debt was spread over the entire euro area banking system. Moreover, the concentration of sovereign debt in national banks also creates a problem for the European deposit insurance in case the potential losses were to be so sizeable that the deposit insurance would have to step-in.

A European deposit insurance with a reduction of national sovereign bond holdings would make crisis management easier. In particular, it would be easier to bail-in sovereign bond holders, thereby providing more fiscal breathing space to governments. Bail-in of sovereign debt will never be easy. It cannot be a standard instrument but it is rather a measure of last resort. However, in certain extreme circumstances, such a bail-in is preferable to financial assistance programmes that would require self-defeating austerity. Full banking union is thus a necessary prerequisite for rendering soft bail-in in case of ESM programme possible

Design of European deposit insurance

Full insurance or re-insurance? How could a European deposit insurance system be designed. Does it require full insurance or only a re-insurance. This question is discussed in Schoenmaker and Wolff (2016) and the below summarizes the piece. To achieve a full decoupling of banks from sovereigns, a full insurance needed. Re-insurance can achieve that only partially.

It makes sense, however, to start EDIS with re-insurance. There are currently many country specificities such as special treatments of which deposits are covered under what circumstances. Another country specificity in Germany is how cooperative banks and savings banks have created their own special deposit insurances (pillar-based deposit insurance system).

Full European deposit insurance and sovereign exposure rules. A full European deposit insurance is only advisable when sovereign debt exposure of banks is being diversified and country specificities as regards depositor treatments are harmonized. Conversely, it is not justified to reduce national sovereign bond holdings through exposure rules without the existence of a full European deposit insurance. In Benassy, Ragot and Wolff (2016), we argue that one may want to consider removing any risk weights in case banks hold a portfolio of all sovereign debts of the euro area. [...]

Full statement

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