The Eurozone’s deposit insurance scheme creates more problems than it solves
25 November 2015
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Lifestyle Economics
24 November 2015
Government and Institutions
Economic Theory
11 November 2024
The European Commission has released its plan for an EU-wide deposit insurance scheme that will, at first, back up and complement existing national deposit guarantee schemes (DGS), and, from 2024, substitute them as the guarantor of EU bank deposits of up to €100,000. The European Deposit Insurance Scheme (EDIS) is part of the EU’s post-crisis measures to create a Banking Union, alongside a Single Supervisory Mechanism (SSM) to monitor EU banks and a Single Resolution Fund (SRF) to cover bailouts of ailing financial institutions. The SRF would be financed by contributions from credit institutions currently covered by national DGS. The goal is to preclude any taxpayer-funded bailouts and to break the sovereign-bank link that left many Eurozone countries on the brink of default after the 2008/2009 banks rescues.
To many, the creation of the Banking Union, and the setting up of a common deposit guarantee scheme within it, is a necessity that recent events in the Eurozone have brought to the fore. However, it is important to understand why we have come to a situation where the only solution deemed plausible to avoid bank bailouts and sovereign bankruptcies is to centralise virtually all financial regulation at EU level.
Firstly, we need a Banking Union because Eurozone authorities are not prepared to let member countries default and thereby jeopardise the integrity of the currency union. This, it must be remembered, is contrary to the euro’s founding principles which mandated that no member would be bailed out, which explains why the Germans have been so reluctant to endorse post-crisis risk-sharing. If the no-bailout principle were respected, then no member country would be called upon to rescue another member country, which would eliminate the need for a Eurozone-wide solution.
Secondly, we need a Banking Union because sovereigns are not prepared to let financial institutions fail. What brought Ireland to the brink in 2010 was its decision two years earlier to guarantee the deposits and debts of its banks in a bid, which ultimately failed, to reassure depositors and markets. Now, it may be argued that in the environment of late 2008, there was no other way for Ireland to weather the storm. However, that implies that we should consider the impact that public policy in Ireland and elsewhere, from fuelling property bubbles to raising barriers to entry in the financial sector to encouraging opacity and concentration in certain instruments, had in magnifying the crisis.
Thus, one may argue that what is now billed as an unavoidable necessity really is just the consequence of a series of bad policy choices, and that outcomes will be suboptimal unless the underlying causes of the problem are decisively addressed. That would mean making financial institutions responsible for their decisions, which in turn would necessitate greater monitoring of banks’ behaviour by depositors and independent agencies. It would go a long way in making bank failures less systemically important and more like failures in other sectors. Secondly, an optimal long-term solution would reinstate the no-bailout principle and make sovereigns responsible for their own choices, and thus less likely to put taxpayers’ money on the line to prop up the banks.
Alas, we live in an imperfect world, and it is the case that the no-bailout clause in the Eurozone is finished, and that banks are likely to remain systemically important in the near and medium term, at least. This can justify the creation of the SSM to monitor banks’ behaviour, the SRF to provide short-term funds to failing institutions, as well as adequate mechanisms to bail in creditors, as included in the Bank Recovery and Resolution Directive (BRRD). It also explains the need for some scheme to prevent bank runs and give depositors access to their funds. However, it is by no means a given that EDIS is the best way to provide such protection and assurance to depositors.
To begin with, EDIS, like other existing deposit guarantee schemes, gets incentives wrong. By fully protecting deposits up to €100,000, it means depositors will have no skin in the game, nothing to lose if their bank goes belly up. This raises the issue of moral hazard, i.e. that depositors will focus on the rewards – the interest and other benefits offered by financial institutions – whilst paying little attention to the associated risks – the soundness of a bank’s balance sheet – because their money is guaranteed by the state in good times and bad. To allow markets to work and competition to flourish in the financial sector, depositors need to face balanced risks and rewards so that they can make their choices efficiently, and so that sound institutions are recompensed and weak ones punished.
A good proposal to combine depositor protection with adequate distributions of risk was advanced by IEA Fellow Andrew Lilico, who in a 2010 paper for Policy Exchange advocated the abolition of current schemes for deposit insurance and their replacement by two types of deposit accounts that all banks would be mandated to offer: a) storage accounts, offering no interest and 100 per cent backed by government bonds; b) investment accounts, offering interest, subject to fractional reserve banking as currently practiced, and uninsured. This would be combined with a system of liquidity insurance which would give depositors access to their funds in times of stress, without removing their exposure to a bank’s failure (because the deposits wouldn’t be insured and any amount taken out which wasn’t recovered in the bank’s eventual bankruptcy procedure would have to be returned).
The above is a realistic proposal to address the concerns of regulators and politicians about deposit protection in the existing banking system, without raising the moral hazard issues that traditional deposit insurance brings with it.
Returning to EDIS, there is another reason why the proposed scheme is problematic, and that is related to the centralised and pan-Eurozone nature of the proposal. Namely, it is a one-size-fits-all approach which guarantees all deposits up to the same amount across the single currency area, without regard to local conditions, needs and the position of the relevant banks and depositors. Without that local knowledge, supervision becomes more difficult. Moreover, in a highly diverse Eurozone economy a single deposit guarantee scheme could enhance the moral hazard problem by turning what is normally a problem of choosing the riskier among domestic banks and domestic projects into a Eurozone-wide problem. Not exactly the kind of free movement of capital regulators are seeking to encourage.
Finally, like other post-crisis initiatives in the single currency area, EDIS contains an element of risk-sharing, by pooling together existing DGS as well as future contributions from banks all across the Eurozone. One wonders whether compromising the integrity of more robust banking systems by linking them together with weaker ones is the right way to go. Of course, Commissioner Hill may well argue that “we act better together” and that EDIS is part of a series of moves to make the Eurozone financial system as a whole more resilient. However, in itself, such pooling of insurance – like any mutualisation of risks – creates a moral hazard problem.
Today’s announcements are an inevitable sequel to the kind of banking system that monetary policy, regulation and public policy have created. Yet, there is room for improvement even while recognising that our ideal solutions are unlikely. The Lilico scheme is one such pragmatic proposal. At any rate, a unified Eurozone DGS follows the trend of centralisation that is causing the EU so many economic and political problems. The time will come when we will have to face the consequences.
Diego Zuluaga is the IEA’s Financial Services Research Fellow and Head of Research at EPICENTER.
To many, the creation of the Banking Union, and the setting up of a common deposit guarantee scheme within it, is a necessity that recent events in the Eurozone have brought to the fore. However, it is important to understand why we have come to a situation where the only solution deemed plausible to avoid bank bailouts and sovereign bankruptcies is to centralise virtually all financial regulation at EU level.
Firstly, we need a Banking Union because Eurozone authorities are not prepared to let member countries default and thereby jeopardise the integrity of the currency union. This, it must be remembered, is contrary to the euro’s founding principles which mandated that no member would be bailed out, which explains why the Germans have been so reluctant to endorse post-crisis risk-sharing. If the no-bailout principle were respected, then no member country would be called upon to rescue another member country, which would eliminate the need for a Eurozone-wide solution.
Secondly, we need a Banking Union because sovereigns are not prepared to let financial institutions fail. What brought Ireland to the brink in 2010 was its decision two years earlier to guarantee the deposits and debts of its banks in a bid, which ultimately failed, to reassure depositors and markets. Now, it may be argued that in the environment of late 2008, there was no other way for Ireland to weather the storm. However, that implies that we should consider the impact that public policy in Ireland and elsewhere, from fuelling property bubbles to raising barriers to entry in the financial sector to encouraging opacity and concentration in certain instruments, had in magnifying the crisis.
Thus, one may argue that what is now billed as an unavoidable necessity really is just the consequence of a series of bad policy choices, and that outcomes will be suboptimal unless the underlying causes of the problem are decisively addressed. That would mean making financial institutions responsible for their decisions, which in turn would necessitate greater monitoring of banks’ behaviour by depositors and independent agencies. It would go a long way in making bank failures less systemically important and more like failures in other sectors. Secondly, an optimal long-term solution would reinstate the no-bailout principle and make sovereigns responsible for their own choices, and thus less likely to put taxpayers’ money on the line to prop up the banks.
Alas, we live in an imperfect world, and it is the case that the no-bailout clause in the Eurozone is finished, and that banks are likely to remain systemically important in the near and medium term, at least. This can justify the creation of the SSM to monitor banks’ behaviour, the SRF to provide short-term funds to failing institutions, as well as adequate mechanisms to bail in creditors, as included in the Bank Recovery and Resolution Directive (BRRD). It also explains the need for some scheme to prevent bank runs and give depositors access to their funds. However, it is by no means a given that EDIS is the best way to provide such protection and assurance to depositors.
To begin with, EDIS, like other existing deposit guarantee schemes, gets incentives wrong. By fully protecting deposits up to €100,000, it means depositors will have no skin in the game, nothing to lose if their bank goes belly up. This raises the issue of moral hazard, i.e. that depositors will focus on the rewards – the interest and other benefits offered by financial institutions – whilst paying little attention to the associated risks – the soundness of a bank’s balance sheet – because their money is guaranteed by the state in good times and bad. To allow markets to work and competition to flourish in the financial sector, depositors need to face balanced risks and rewards so that they can make their choices efficiently, and so that sound institutions are recompensed and weak ones punished.
A good proposal to combine depositor protection with adequate distributions of risk was advanced by IEA Fellow Andrew Lilico, who in a 2010 paper for Policy Exchange advocated the abolition of current schemes for deposit insurance and their replacement by two types of deposit accounts that all banks would be mandated to offer: a) storage accounts, offering no interest and 100 per cent backed by government bonds; b) investment accounts, offering interest, subject to fractional reserve banking as currently practiced, and uninsured. This would be combined with a system of liquidity insurance which would give depositors access to their funds in times of stress, without removing their exposure to a bank’s failure (because the deposits wouldn’t be insured and any amount taken out which wasn’t recovered in the bank’s eventual bankruptcy procedure would have to be returned).
The above is a realistic proposal to address the concerns of regulators and politicians about deposit protection in the existing banking system, without raising the moral hazard issues that traditional deposit insurance brings with it.
Returning to EDIS, there is another reason why the proposed scheme is problematic, and that is related to the centralised and pan-Eurozone nature of the proposal. Namely, it is a one-size-fits-all approach which guarantees all deposits up to the same amount across the single currency area, without regard to local conditions, needs and the position of the relevant banks and depositors. Without that local knowledge, supervision becomes more difficult. Moreover, in a highly diverse Eurozone economy a single deposit guarantee scheme could enhance the moral hazard problem by turning what is normally a problem of choosing the riskier among domestic banks and domestic projects into a Eurozone-wide problem. Not exactly the kind of free movement of capital regulators are seeking to encourage.
Finally, like other post-crisis initiatives in the single currency area, EDIS contains an element of risk-sharing, by pooling together existing DGS as well as future contributions from banks all across the Eurozone. One wonders whether compromising the integrity of more robust banking systems by linking them together with weaker ones is the right way to go. Of course, Commissioner Hill may well argue that “we act better together” and that EDIS is part of a series of moves to make the Eurozone financial system as a whole more resilient. However, in itself, such pooling of insurance – like any mutualisation of risks – creates a moral hazard problem.
Today’s announcements are an inevitable sequel to the kind of banking system that monetary policy, regulation and public policy have created. Yet, there is room for improvement even while recognising that our ideal solutions are unlikely. The Lilico scheme is one such pragmatic proposal. At any rate, a unified Eurozone DGS follows the trend of centralisation that is causing the EU so many economic and political problems. The time will come when we will have to face the consequences.
Diego Zuluaga is the IEA’s Financial Services Research Fellow and Head of Research at EPICENTER.
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Couldn’t agree more with the moral hazard problem.
Wouldn’t a better way to address it be that only part of the money is protected, say 80%? The investor loses the rest.
That would protect most investors from catastrophic loss while providing an incentive to assess the financial stability of the organisations you place your money with, and reducing the cost to the taxpayer.