Banking Union: what options for the third pillar?
The Great Recession, followed by the euro crisis, created a momentum for the realization of the Banking Union to reduce financial fragmentation, weaken the bank-sovereign nexus and enhance monetary policy transmission. The recent turmoil in the banking sector yet starts to raise doubts about its efficiency (Eurointelligence). The eventual weaknesses can be better understood by looking at how it was built.
The Banking Union is designed with three interconnected pillars, each being an indispensable complement ensuring the efficiency of the other—hence raising the question of effectiveness in case of improper or incomplete implementation. Progress is uneven: the Single Supervisory Mechanism (SSM) is complete, the Single Resolution Mechanism (SRM), effective since January 2016, sees a gradual implementation, while the Single Deposit Guarantee Scheme is still under discussion.
Banking Union: from fragmentation to integration
The meltdown in the US banking sector led to solvency and liquidity problems in the European banking sector (Mink and de Haan). Several governments had to bail-out banks leading to a heterogeneous deterioration of country fundamentals and finally to financial fragmentation (Beirne and Fratzscher, 2013).
Bailing out banks weakened public finances, which in turn had a negative impact on national banks holding sovereign bonds. This vicious circle was called the “negative feedback loop” (De Grauwe, 2013).
Moreover, the amplified financial fragmentation impaired monetary policy transmission as the credit channel was broken during the crisis (Al-Eyd and Berkmen, 2013).
The crisis, hence, revealed the need for better supervision and regulation of the banking system and the three-layered Banking Union project was proposed (European Council).
With the implementation of the SSM the ECB has become the supervisor of Eurozone’s 130 largest banks (holding 85% of all assets). It ensures the stability and solidness of bank balance sheets through the Bank Recovery and Resolution Directive (BRRD) and a common resolution framework for all EU credit institutions. The SRM along with the SSM will weaken the sovereign-bank nexus, by transmitting the responsibility of bailouts from sovereigns to a supra-national level (through the Single Resolution Fund). The Deposit Guarantee Scheme (DGS) is aimed at restoring public confidence in the banking system and avoid bank runs, by insuring deposits (Library of the US Congress Blog).
However, the design of the project has caused some contradicting opinions. For example, some argue that the SRF will be insufficient to deal with large shocks (Raoul Ruparel), hence there will still be need for bailouts. And this will not fill the gap between northern core and southern periphery; according to Philippe Legrain “Germany can afford to bail out its bank, Italy cannot”. Another problem, in Silvia Merler's view, is that divergence in national interests might hamper day-to-day functioning. For example, countries still have a veto over closing down any banks and the final decision is still in the hands of national governments. Besides, the resolution process is supposed to be quick, with an entry into force within 24 hours after the decision. However, the Council can contest the Single Resolution Board conclusion, delaying the resolution.
The DGS also has some flaws, which were laid bare during the past years. The original Directive on DGS – adopted in 1994 – was not changed substantially for about 15 years. The national DGS had significant differences in their coverage, contributions, fund size, and organizational setup (IMF). It gave countries incentives to build stronger systems in order to attract foreign capital, entering into an unhealthy competition. A good illustration of this is Ireland and the countries following its example in 2008. This situation raised a need for harmonization, achieved in 2009 and 2014.
Debates about the third pillar: towards a European Deposit Insurance Scheme (EDIS)?
1. From national deposit guarantee schemes (DGS) to an eu system?
The “new” DGS was officially launched in June 2014. It applies to all EU countries on the national level and can be seen as a harmonization of national deposit guarantee schemes: repayment deadlines, enhanced transparency and a 100.000€ coverage.
Deposits (from individuals and small companies) are covered per depositor and per bank. Currently, depositors are able to access their funds within 20 working days after a bank failure. With the new law, repayment deadlines will be gradually reduced to 7 working days. The new Directive also aims to improve depositor information about key aspects of protection.
Funding: In principle, the minimum target level for ex ante DGS funds is fixed at 0.8% of covered deposits (i.e. about € 55bn), to be reached within 10 years. Currently, schemes in about half of member states have already reached the target level or are close to it (European Commission). In one third of the states, DGS funds are above 1% of covered deposits. This excess of protection in some countries creates incentives for depositors to place savings in the system with the most generous DGS (IMF). In time of stress, it can become a competitive advantage (Hardy and Nieto).
According to the IMF, such differences must be eliminated. Any divergences, perceived or real, among national DGS can contribute to market fragmentation by affecting the ability and willingness of banks to expand their operations across borders.
Moreover, national funds remain insufficient in case of local systemic crises (BBVA). This calls for a merger of existing funds. Indeed, the bigger the pool, the better risk absorption and the least the probability of fund exhaustion.
All these arguments created grounds for mutualizing national schemes. As a consequence, the European Commission, the Five Presidents report, and several economists have argued in favor of a European deposit insurance scheme.
2. The EDIS project
In November 2015 the European Commission has unveiled its plan for the next pillar of the Banking Union – a common insurance scheme for bank deposits.
The aim of establishing EDIS is to further harmonize depositor protection and enhance the credibility of guarantee schemes. However, the feedback from certain countries, Germany in particular, has already been reluctant and the debate is heating.
The project (for Banking Union member countries: Euro area + EU participants):
A “re-insurance” plan: between July 2017 and July 2020, national deposit guarantee schemes will continue to support covered deposits up to €100.000 but can demand support from the European scheme if their funds are exhausted.
A “co-insurance” scheme: from July 2020 to July 2024 the national and European schemes will work in conjunction to backstop covered deposits. The European scheme will initially foot 20% of the bill, but the threshold will increase over four years.
From July 2024 the European fund will fully back covered deposits. Decisions will be taken via simple majority with each member having one vote. By 2024 the fund will be complete, with contributions of around €6.8bn per year by banks, with riskier banks paying more.
Main improvements brought by EDIS
Enlarging the fund: in case of financial distress, a country has access to €55bn instead of 0.8% of its national deposits, which lowers the systemic risk.
Ending bank runs: if the deposit insurance system is credible, depositor confidence will be enhanced, avoiding possible bank runs and improving financial stability.
Weakening the bank-sovereign nexus: according to the Five Presidents report, EDIS will be necessary for completing the banking union and weakening the bank-sovereign nexus without need for a treaty change. Indeed, at a national level, DGS credibility depends on the amount of paid-in resources, the health of the banking and public sectors. Funding costs for banks, i.e. deposit rates, therefore vary across euro area countries.
Financial defragmentation/benefits for cross-border activity: Greater confidence induced by system harmonization is supposed to enable greater lending to the economy at the local and cross-border levels, especially for countries with many multinational banks (Sandholtz & Stone Sweet, 2010).
Limits of the project
There are still divergent views amongst EU governments, Germany being reluctant to such a system (Bruegel): the objective should be risk minimization instead of risk mutualisation (Warning Signals). Indeed, a European fund would first require limiting preferential regulatory treatment of government bonds (Bundesbank). This topic is politically sensitive and a treaty change might be necessary. Furthermore, some design weaknesses in the EDIS project can be pointed out.
Size of the fund: Compared to the $ 500bn of US FDIC, the European fund is rather small, even if it can borrow further if resources are exhausted. This can put credibility under question from the depositor point of view in case of large crises (Sibert ).
Weaknesses before the full implementation: Before 2020, EDIS will cover only 20 % of insured deposits in case national funds are exhausted, and the rest will be paid by the national government. This will not allow avoiding the “doom-loop” before the full implementation of the third pillar (Euractive). The German finance ministry stresses that risks in the banking sector should be minimized, and not shared out or mutualized. Thus, the nexus between sovereigns and banks should be weakened further before EDIS implementation (Reuters).
Absence of a common fiscal backstop: A common fiscal backstop is an important missing element in the current proposal. It would have acted as a last resort instead of bail-outs (BBVA).
Remaining threat of bank runs: The phenomenon of deposits fleeing banks (e.g in Greece) has come about majorly because of a re-denomination risk and fears about a crash out of the euro area. A deposit insurance scheme does not tackle that risk. Moreover, as showcased by the situation in Cyprus in 2013, in a growing risk situation big investors can withdraw their funds, causing financial instability even if banks retain all the small deposits.
Diverging interests: In the depositors’ point of view, EDIS will worsen the protection in countries that reached a higher level than the minimal 0.8% (e.g Germany and Austria). Indeed, in these countries most banks contribute to additional insurance funds (Richard and al, 2003).
3. How to reach a consensus?
Besides weaknesses in the design itself, the project allows for some debate at the political level (Paul Krugman).
First, the unified system may create a risk of moral hazard and free-riding. National economic policy still has a major bearing on domestic banks’ financial situation and insolvency legislation is far too divergent across Banking Union member countries (Bundesbank).
Second, weakening the bank-sovereign nexus might be a pre-requisite and not a consequence. The implementation of a credible bail-in approach should be completed to ensure an efficient functioning of the Banking Union, according to Raoul Ruparel. In 2015 banks still hold large amounts of government bonds. Imposing a limit on such holdings could be more efficient to break the sovereign-bank link (Eurointelligence).
Finally, as long as national governments are the back-stops to banks, sovereigns prefer to have control over their banks (Schoenmaker and Wolff 2015). For instance, Germany suggested shifting some responsibilities from the SSM to the German Finance ministry (Bruegel). Another option is to unite the Single Deposit Insurance with the Single Resolution Fund and administrate it by an enlarged Single Deposit Insurance and Resolution Board (Gros and Schoenmaker, 2014). A final point to consider is the transparency of bank information. In the USA, for example, banks can benefit from the deposit insurance fund only if they provide required information to the supervisor. This rule should ideally apply under EDIS (Bruegel).
Conclusion
Whatever form the third pillar takes, it relies on the efficient functioning of the Supervisory and Resolution Mechanisms. Before parties reach a consensus, a reinsurance plan could be an intermediary solution: staying at a national level with a common backstop (Deutsche Bank). The reinsurance fund may be financed by premia collected from national schemes (D. Gros). The network of DGS could also be strengthened and possibilities for bilateral lending considered.
