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BrackenJanuary 4 2016

Getting eurozone deposit insurance right promises benefits

The knee-jerk reaction from Germany overlooks the potential benefits of an EU-wide deposit insurance scheme for the whole European banking system.
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The European Commission presented its proposals for European deposit insurance in late November 2015. Officials hope to stabilise the banking system and decouple banks’ financing costs from the solvency of their host states. This would achieve the original aim of the eurozone banking union: to break the link between states and their banking systems.

Under these proposals, the cost of bank rescues and deposit insurance would no longer be borne exclusively by individual countries, but by the eurozone as a whole. This would be a momentous step, which can only be successful if both the fine details and the whole structure have been carefully considered. German critics have called the proposal an “attack on German savings”, but in the end this move is vital if we want to build a sensible and successful banking union.

Potential model

There are various potential models for a European deposit insurance scheme. The most fundamental differences concern the size of the national and European components.

One possibility would be to leave deposit insurance a purely national matter, as is currently the case. In this case the credibility of the insurance depends on the size of the insurance fund, and the health of the national banking sector and state finances, since deposit insurance schemes generally call on the state as a backstop guarantor. The financial crisis showed that this final aspect can be problematic when states do not have sufficient resources. This creates major tensions in the banking system, which in turn place burdens on the European Central Bank (ECB) that push it to the limit of its mandate.

An alternative proposal is a deposit insurance scheme entirely at the European level. The quality of the deposit insurance would thus be totally independent of the individual countries’ policies. However, this would create a problem with incentives, where truly shared liability tempts policy-makers to dump costs on others. States with less rigorous rules might feel only weak pressure to improve the regulatory framework of their financial system. This could lead to reluctance to impose macroprudential rules such as minimum loan-to-value ratios for mortgages or the treatment of foreign currency loans. Even more relevant, though, is the large exposure of banks to sovereign debt – here there is clearly a need for action.

Sovereign debt dilemma

A model where a European deposit reinsurance scheme retains a certain national component would be a compromise between these extremes. Countries would keep their national deposit insurance schemes and only call on a European pool if national funds are insufficient. National insurance schemes could pass a portion of the contributions that they collect from banks to the European pool. These contributions could be set at country-specific rates in order to take account of national risks.

Such a system would indeed reduce the risk of so-called 'moral hazard'. But the ties binding the banking sector to national fiscal and economic risks would only be weakened, not fully severed. Therefore, in the long run, this cannot be seen as a satisfactory end point for banking union.

One of the main problems with the current situation – which would also affect the compromise solution sketched out above – is that the ECB’s single supervisory mechanism (SSM) is pitted against strong national responsibilities. Because national differences remain, governments would understandably want to get involved in the supervision of banks as well. On the other hand, national governments would have a strong case if they refused to meet their liabilities for problems that were not discovered in good time by the SSM.

A coherent solution would be to create a European deposit insurance and resolution authority. Much like the US Federal Deposit Insurance Corporation this authority would take total responsibility for the insurance of deposits. It could fall back on reinsurance from the European taxpayer if even tough bail-in rules are not sufficient to pass on losses to private creditors. However, we can only implement such a system credibly if banks become fundamentally 'European', and in particular if they hold fewer government bonds on their books.

A common upper limit on the proportion of government bonds on banks’ balance sheets is thus a vital prerequisite for European deposit insurance. The link between banking sectors and states lies not only in implicit and explicit liability; it lies primarily in the huge quantities of domestic government bonds that banks buy.

Germany, which is strongly opposing a true Europeanisation of deposit insurance, also has much to gain if Europe’s banking system can finally achieve stability. It can only be won over, though, if this risk sharing is complemented with risk reduction. For one, the ECB would no longer have to assume indirect liability. The German and European banking systems would also become more efficient, since loans would be approved according to economic rather than political criteria.

Guntram Wolff is director of the economic think-tank Bruegel in Brussels.

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Read more about:  Analysis & opinion , Bracken , Western Europe