Paul N Goldschmidt: Designing a credible European Deposit Guarantee Scheme

04 December 2012

The Deposit Guarantee Scheme creates a series of specific problems that makes agreement among the EU 27 or 17 particularly difficult, comments Goldschmidt.

Creating a European Deposit Guarantee Scheme (“DGS”) is an intrinsic part of the wider European “Banking Union” endeavour which encompasses, in addition, a Single Supervisory Mechanism (“SSM”) and a European Bank Resolution Mechanism (“EBRM”).

Recognising that the design and implementation of all three legs must be considered in a coherent and coordinated fashion, this paper, nevertheless, addresses specifically the DGS which creates a series of specific problems that make agreement among the EU 27 or 17 particularly difficult. This should not come as a surprise, as the objective of “mutualising” the risk involved in a single European-wide DGS encounters some of the same objections as mutualising the risk on sovereign debt issuance (“eurobonds”) but on an even larger scale. Indeed, rather than covering a gradually increasing but controllable amount in case of “common issuance”, a DGS would mutualise, from its inception, the guarantee of a very large amount of EU bank deposits.

A key element of the creation of an EU DGS will be to provide a credible funding mechanism. Its design should ensure that ultimate recourse to “taxpayers” is as remote as possible. This can be achieved in several ways such as: limiting the liability of the insurance policy and/or charging sufficient insurance premiums to cover potential losses.

Reducing the liability of Member States (“MS”) which, at present, guarantees an amount of €100,000 per deposit account, may require a “transition period”, during which their exposure is be reduced progressively as a permanent “guarantee fund” increased in size through the contributions of depositors. A “residual” liability, aimed at covering exceptional “systemic risks”, may have to be borne by MS according to a predetermined “burden-sharing agreement”, but this particularly sensitive question should be easier to resolve if recourse is made sufficiently remote.

In the name of the “free movement of capital”, and also in recognition of the many legitimate reasons for opening accounts in different jurisdictions, it may prove difficult, if not counterproductive, to institute a limitation of the number of separate “insured accounts” owned by a single depositor. This should not preclude creating the optimal conditions in order to reduce the incentives for diversifying the number of accounts which contribute to the “fragmentation” of the banking market, thus achieving one of the key aims of the Banking Union: underpinning a single financial market within the EU/EMU, in which the Gordian knot between national banking systems and their respective governments has been definitively broken.

An EU DGS should impose a Union-wide tariff for deposit insurance but which could be differentiated according to “objective” criteria:

• The type of deposit institution: the risk profile of the institution, as determined by the Regulator, would be a first criterion. A major consideration would be the degree of segregation between traditional commercial banking and other activities: this could range from total separation, along the “Glass Steagall” model, to universal banking, including intermediary models such as Volker, Vickers, Liikanen, etc. The “insurance premiums" charged to depositors in these different types of institutions should be modulated according to the classification.
• The capital structure of the institution: a major criterion should be the amount of the capital base relative to deposits. This should, however, be adjusted for the amount of liabilities that rank either in preference to depositors (i.e. liabilities guaranteed by the pledge of assets) or pari passu with depositors.

These first two criteria aim at reducing the risk profile of the institutions that are most likely to attract deposits by being able to offer lower “insurance premiums” to their depositors.

• Graduating the premiums according to the size of the deposit: A graduated annual premium payable quarterly and calculated on the “average balance” held. (Example for a traditional well-capitalised commercial bank: 0.25 per cent up to €25,000, 0.5 per cent up to €50,000, 0.75 per cent up to €75,000 and 1 per cent up to €100,000). This aims at protecting the vast majority of very small depositors at a reasonable cost.
• A separate scale for “non-resident accounts”: set, for instance, at double the rate for residents. This is aimed specifically at discouraging fragmentation of the EU/EMU banking market having removed - through the mechanism of the Banking Union - the main reason for its existence.

Each bank would be required to inform depositors of its classification under the first two criteria and the corresponding “premium” for DGS protection. The other criteria would be automatic and subject to application of the requisite “multiplier”.

It is very important that small deposit accounts be insured at the lowest cost possible. One alternative would be to make the premium on accounts of up to €25,000 payable by the bank itself, exempting it, as a quid pro quo, from remunerating such accounts.

Pricing guarantee premiums for accounts in excess of €25,000, to reflect fully the risks involved, would seem amply justified. The insurance could be made optional, giving the depositor a choice; uninsured deposits would rank pari passu with other unsecured senior debt and be subject to bail-in provisions envisaged within the scope of the EBRM. High premiums should also encourage depositors to “invest” their excess savings in more “productive” instruments rather than seeking the shield of a “State” low cost – taxpayer funded - and possibly mispriced protection.

Such an approach would imply, in all likelihood, limiting its scope to the Eurozone, rather than to the EU as a whole, as it requires full compatibility with both the SSM and the EBRM.

While instituting such a system may appear unwieldy and unnecessarily complex, its practical application would most likely lead to a dramatic simplification: institutions would either aim at attracting deposits, striving to achieve the lowest premium rates for competitive reasons, while others, whose business models are based on investment banking/trading activities, are likely to forgo any deposit taking activities bringing the market “voluntarily” to a structure close to conditions of the erstwhile Glass-Steagall.

It has been correctly pointed out that most banking failures have been due to traditional banking activities (excessive real estate lending, consumer finance, etc. on the asset side, and funding mismatches or excessive leverage on the liability side) rather than to high risk activities including proprietary trading (with the notable exceptions of Lehman Bros and Bear Stearns). However, a “market led” structural simplification could significantly facilitate the implementation within the eurozone of an adapted “FDIC” model (combining the DGS with the EBRM) which has served so well the resilience of the US banking sector. The implementation, in parallel with the DGS and the EBRM also provides additional protection to depositors and reduces commensurately the risk exposure of taxpayers.

Finally, by ensuring that depositors contribute significantly to the “guarantee fund” and that they are well protected within the capital structure of the bank, the objections to a State underwriting a EMU-wide DGS are considerably reduced, being largely limited to “systemic” risk for which it is fully appropriate that the burden be mutualised among all eurozone participants.

Paul N Goldschmidt, Director, European Commission (ret); Member of the Advisory Board of the Thomas More Institute

Tel: +32 (02) 6475310 / +33 (04) 94732015 / Mob: +32 (0497) 549259

E-mail: paul.goldschmidt@skynet.be / Web: www.paulngoldschmidt.eu

© Paul Goldschmidt