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Is the Eurozone Doomed to Fail without a European Deposit Insurance System?

 5 min read / 

EU member states’ fiscal positions and domestic banking systems emerged weakened from the Great Financial Crisis, and this fragility has transformed into structural issues in the case of the bloc’s periphery economies. As a result, after many years of stability, the European credit default swap (CDS) spreads on sovereign debts suddenly spiked during the aftermath of the financial crisis, with a peak in 2011. Once again, sovereign risk became a significant variable for the financial sector. Although the spreads have converged in the recent years, the differences are still substantial, signalling vital threats to the future of the EU.

Sovereign risk impact

The issue for domestic banks, holding all other factors equal, is that they have to suffer the burden of sovereign risk with higher costs of funding compared with other banks operating in safer countries. Sovereign risk implies a premium on the cost of deposits. Apparently, this premium reduces the domestic banking sector’s ability to offer its service to the real economy, limiting the possibility of a recovery in the countries most affected by the crisis.

The Loop

Sovereign fiscal positions, the domestic banking system and the economy constitute a “diabolical loop”, as the Centre for European Policy Studies calls it – which describes perfectly the condition in which many peripheral countries sit, that, if not reversed, poses many risks for the future of Europe as a unified entity.

In fact, the divergences exacerbated by this effect could ultimately end up with the exit of the weaker countries from the EU. The reasons can be found in the social responses deriving from a struggling economy, which recently contributed to feeding the populist movements emerging in Europe. Moreover, there is the inability of some countries to respect financial requirements in a sustainable manner if the state of the economy does not improve in the foreseeable future.

The Solution in a Legislative Proposal

Thus, since 2012 the European Commission has tried to reinforce the monetary union with a project aimed at reaching a banking union. The banking union aims are:

  • To ensure the resilience and smooth functioning of the banking union
  • To increase legal certainty
  • To contribute to overall stability in the euro area
  • To ensure a level playing field for all banks in the banking union

For the banking union to come to fruition, there needs to be a shift of supervision to the European level, the establishment of a single framework for bank crisis management and a common system for deposit protection. The first two steps have been achieved by the establishment of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM), but in this framework is still missing a European deposit insurance system (EDIS).

The institution of a European deposit insurance system would constitute the third and fundamental pillar of the banking union. In fact, the strongly stated objective of a common deposit insurance system, as the European Council puts it, is to “provide stronger and more uniform insurance coverage for all retail depositors in the banking union than the currently existing national systems of guarantee. That would in turn help increase depositor confidence and ensure a level playing field for all the banks in the banking union, contributing to greater financial stability in the euro area in general.”

The Rationale

In particular, levelling the playing field is essential to breaking this existing loop. The reason why it is necessary to move deposit insurance from a national level to a European one is that deposit guarantees are currently national schemes for which credibility depends on the standing of the national public institutions. For this reason, funding costs for banks, i.e. deposit rates, are different across eurozone countries depending on the credibility of the country’s scheme, and this could be seen as an implicit state subsidy on funding costs of deposits.

The European deposit insurance system would achieve the result of correlating the banks’ funding costs only with their solvency positions, while eliminating the premium that is currently added based on the bank’s location of headquarters. Thus, the EDIS would solve the problem and strengthen domestic banking institutions, breaking the chain that ties them to sovereign risk in the first place.

Issues in the Process

Although the implementation of the European deposit insurance system is a theoretically sound answer to the problem, another reform is needed before. In fact, the fundamental principle behind the third pillar is that its implementation would break the connection between the domestic banking sector and sovereign risk.

But in practice, this would not happen: at the moment, under the current regulation, banks are allowed to carry sovereign debt on their balance sheet as a default-free asset. This issue implies that, alongside the EDIS, another reform entailing the risk-weighting and concentration of sovereign debt on banks’ balance sheet would be necessary.

As stated by the Eurogroup President Dijsselbloem: “If you want a European deposit guarantee, risks should be reduced first,” adding “One of them is a high concentration of government debt on the balance sheets of several banks. That should be dealt with.”

In fact, the political opposition of countries like Germany would certainly be insurmountable unless a sovereign debt risk reform is enacted. Moreover, the fact that peripheral banks’ risks of losses are higher in the short term (due to their current financial condition) requires the implementation of two phases, before achieving a complete EDIS by 2024 when the fund would be fully funded.

The Need for Change

The EU needs a European deposit insurance system to guarantee its survival in the long term, but this action must include other reforms regarding the risk reduction of the banks involved in the plan. This change is fundamental to rendering the EDIS politically acceptable and efficient in achieving its goals.

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