04 July 2013

Charles Wyplosz: A European Deposit Guarantee Scheme?

In this Briefing Paper for ECON's Monetary Dialogue, Wyplosz writes that as the ECB must lie at the heart of deposit guarantees, this in turn creates the need to adopt clear rules of engagement, including sharing rules to meet potential residual costs or profits.

Executive Summary

Banks are inherently fragile. Because they operate maturity transformation – borrowing very short in the form of freely withdrawal deposits by their customers – they never have enough cash to pay back all deposits simultaneously. They are open to the 'multiple equilibria' phenomenon. When trusted by their customers, they only need very little cash at hand. However, if customers wrongly fear for their deposits, they collapse as they cannot satisfy massive withdrawals. The purpose of a Deposit Guarantee Scheme (DGS) is to make massive panic withdrawals pointless. Credible DGSs in effect eliminate the bad equilibrium.

DGSs exist in a very large number of countries. To be credible, they must have immediate access to resources large enough to rapidly reimburse all depositors who want to withdraw their monies. What are those resources? In some countries, some funds have been established but they are always too small to match all guaranteed deposits. In the event of a full-fledged banking crisis, the government must instantly mobilise massive amounts that can reach 50 per cent to 100 per cent of GDP in the worst cases. This is why the ultimate guarantor can only be the central bank, which has the possibility of creating unlimited amounts of money on behalf of the government.

In the euro area, it is the ECB that can act as lender of last resort. In order to be able to fulfil this function, the ECB needs a number of guarantees. First, it must have real-time and accurate information of the situation of all banks, hence the need for a single supervisor. Second, it must be reassured that the resources that it provides will be used wisely, protecting depositors and not banks with a view of shielding taxpayers. This calls for an independent resolution authority. Third, because its interventions can be costly, an arrangement must work out to cover possible losses.

On the other hand, a common DGS does not require a common fund. The reason is that a fund of adequate size would reach more, possibly significantly more than 50 per cent of GDP. Anything less would be insufficient in the face of a generalised banking crisis. It is not necessary either once the way is cleared for the ECB to be able to act as lender in last resort.

A common DGS would involve a formal commitment by the ECB to honour the guarantee in the event of a bank failure. This, in and by itself, is enough to stem bank runs. The more complex question is how to deal with a bank failure, an event bound to occasionally occur.

As lender of last resort, the ECB will be necessarily involved, through the DSG and possibly the resolution of the bank. This is why DSG and bank resolution are intimately related. While a well-managed resolution ultimately does not have to involve costs, and can even be profitable, the issue of who will bear the losses, or share in the profits, must be dealt with ex ante.

Full paper

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