Deposit Guarantee Schemes: The Road to pan-European Depositor Protection
The creation of the European Banking Union, initiated in 2012 in order to make the European banking system more efficient, consistent and robust, is getting up to speed. Time for Sia Partners to analyze the current state of the three pillars by dedicating a series of three articles to the Banking Union.This article is number three in the series.
This article focuses on the final pillar - the Deposit Guarantee Schemes (DGS) - its practical implications and the potential consequences on the European financial services industry.
A DGS provides a degree of protection for account holders' savings at the moment when a financial institution is unable to effect repayment due to insolvency. A European deposit insurance harmonization process started in 1994, but the 2008 financial crisis and Euro crisis once again pinpointed the adverse consequences that depositor insecurity, herd behavior and self-fulfilling panics can have on the banking system. Hence, DGS aim to improve the security of the European banking system and restore the confidence of creditors, investors and savers, by guaranteeing safe deposits in case of bank instability through the collection of ex-ante funds funded by the banks themselves.
Harmonization of DGS for a strong Banking Union
In the past, DGS across the EU were largely fragmented, and the issues arising from differing member state regulations led to insecurities, doubt and confusion on deposit insurances in case of systemic crises. Issues like the debate on deposit levies in Cyprus, or foreign investors being left out of protection by the Icelandic government after failure of one of Iceland's largest banks, gave rise to calls for EU harmonization of DGS. Therefore, the EU aims to create a level playing field between EU member States and further promote EU financial integration through uniform protection of all European depositors in European banks. Uniformity means no possible arbitrage by financial institutions and no arbitrage by depositors in search of the greatest protection. The current EU harmonization of DGS can be summarized in the below table.,,,
The uniform € 100 000 threshold is calculated as a sufficiently high amount to protect "small depositors", but a small enough premium to discourage moral hazard behavior on behalf of depositors in their selection of banks. This along with the fact that higher risk financial institutions pay higher premiums aims to alleviate all moral hazard risk associated to deposit insurance.
DGS and Bank Resolution
DGS funds can also be applied for bank resolution (cfr. Single Resolution Mechanism), because this is in most cases cheaper than paying out depositors, while sharing the same goal of protecting depositors against the unavailability of their deposits - by maintaining the function of the banks and avoiding contagion. Resolution is preferable to issuing the claim because depositors can then have continuous and unlimited access to their full accounts (as opposed to a one time € 100 000 payment). The choice is up to each individual DGS, but the ECB can guide in the decision. Preference is given to resolution if the estimated cost of maintaining the continuity of systemic functions of the bank and restoring confidence is inferior to a full DGS pay-out of depositors. The pecking-order of resolution funds applied to European banks in financial trouble is summarized in the below table. ,
Impact of third pillar on European Banks
The main impacts and effects of the EU DGS directive on European Banks can be summarized in the figure below.
The main point of concern for banks is obviously the fact that the amount of contributions expected from them is once again raised, adding an additional burden onto the already increased contributions through SSM and SRM.
The Road to pan-European central DGS
Although much effort has been realized to the EU harmonization of DGS, there is still ample room for improvement. The EU commission found that currently, not a single DGS fund could cope with a failure of a large cross-border banking group. In the long term, a full Banking Union would entail one common European DGC fund, with full collection, payout and coordination authority. This would save transaction costs, administrative costs, and would allow for greater stability due to a cross-border safety net. However, pan-EU DGS integration is not yet feasible given the current banking structure, hence the current stepwise approach. The speed at which these regulatory steps succeed each other waits to be seen and will depend on the proven safety of the current structure in case of a future systemic crisis.
Gerhardt, M. and Lannoo, K. (2011) Options for reforming deposit protection schemes in the EU. ECRI policy brief No.4.
Acharya, V., Santos, J. and Yorulmazer, S. (2010) Systemic Risk and Deposit Insurance Premiumsl