A) The first proposal is to provide liquidity to a national deposit insurance scheme when it runs out of money due to a mid-sized or large bank failure;
B) An alternative would be a credit line to the national deposit insurance from a supranational fund such as the European Stability Mechanism or a European deposit insurance fund;
C) A third proposal, advocated strongly by Gros in 2013 and, as a crisis measure, by Véron in 2012, is to create a re-insurance scheme;
D) The fourth proposal is to create a European deposit insurance fund
So how do these schemes compare overall? We do not consider options A and B as a European deposit insurance scheme. Rather, they constitute credit lines that enhance the credibility of the national deposit insurance schemes but they do not insure risks other than liquidity risks across borders. Markets would still differentiate between a bank’s country of origin. Banks from countries with weaker government finances would pay higher funding costs. Our contention is that this differential will remain in the first two proposals, as the deposit insurance arrangements remain basically national. Moreover, the governments will still want to top up the single supervision of the ECB with national supervision, because of the exposure of the national deposit insurance scheme to a domestic bank failure.
A deposit re-insurance scheme, however, has a number of advantages and disadvantages. The advantages of this scheme are clear. It would recognise that currently some banking policies remain national. The first loss would remain with the national schemes in order to reflect the fact that some national policies matter for bank performance. For example, loan-to-value ratios for mortgages differ across Europe and thus influence the riskiness of mortgages on bank balance sheets. The disadvantage, however, is that country differences for banks would remain significant. In particular, national supervisors would rightfully want to have a special supervisory relation with the banks for which their national deposit insurance would have to take the first loss.
Moreover, the percentage that is national in the insurance is an important variable driving the effectiveness of the scheme. If the national percentage is high, significant differences between countries’ banking systems would remain, in particular as the national depositors would have the responsibility of re-financing the fund after a bank rescue. In fact, a large national component could even introduce an element of significant vicious circles as the failure of one bank would make deposits in other banks more costly due to the increased levy. In contrast, if the national first-loss tranche is rather small, the system moves closer to a system in which it resembles a European deposit insurance, option D.
By contrast, the fourth proposal would provide for Eurozone wide risk sharing. In that way, bank funding costs would still be different according to a bank’s solvency position but no longer by its location of headquarters. The advantage of such a scheme would be that the quality of deposit insurance would be equalised across countries. Such a scheme would also best correspond to a centralised supervision by the Single Supervisory Mechanism and could be compulsory for all the banks directly supervised. However, the scheme would also require that other national policies cannot be used in a way so as to free-ride on the European insurance, creating potentially significant moral hazard problems.
To conclude, a genuine banking union that fulfils the aim of “breaking the vicious circle between banks and sovereigns” would require option D. This option, however, raises questions as regards transition problems as well as governance when some national policies remain in place. Before providing such a full European deposit insurance, it is certainly necessary to reduce the national sovereign risk on banks’ balance sheets, for example by introducing some form of large exposure rules. Also, a full European deposit insurance would require a European fiscal backstop.
In contrast, option A and B would not per se justify any move in the direction of large exposure rules as the national sovereigns remain the ultimate back-stops.
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