In search of a third pillar - why is the European Insurance Deposit Scheme crucially needed as part of the European Banking Union?

By Luka Pejic

The European Banking Union will not be completed without adding to its construction the last supporting pillar – the European Deposit Insurance Scheme. With it, the EU will witness a disconnection of the balance sheet of the banks and their national governments. A supranational deposit guarantee mechanism throughout the territory of the Eurozone is necessary to prevent panic if a bank becomes unviable, and to provide stronger and more uniform depositor protection for the Eurozone while improving the distribution of the bank failure costs – reducing the losses endured by central banks in the failure scenario.

For the deposit insurance system to be effective, it must be established before an uncertain period occurs, and the system should be organized in such a way as to reduce the possibility of moral hazard, principal-agent problems, and negative selection. With the emergence of the crisis at the beginning of 2008, the theoretical foundations that until then pointed to the importance and rule of determining the amount of deposit insurance were abandoned because the crisis caused the need for a higher protection limit. Right now, the EU is once again faced with a crisis and instead of delaying the third pillar at this moment, the EU should push for the further solidification of the other two pillars – namely with the currently ongoing Crisis Management and Deposit Insurance Framework revision.

The Banking Union, although incomplete, and the Single Rulebook was a framework that helped the EU weather the COVID-19 and current energy crises. Coordinated fiscal and monetary responses prove that additional deepening is quintessential. Increased resilience has been enjoyed only because of having a strong first two pillars, enshrined with a Single Supervisory Mechanism, and a Single Resolution Mechanism – which was and continues to be proven with concrete cases (European Central Bank, 2022) – addressing the vulnerability of the system involving a vicious circle between bank balance sheets and sovereign debt.

Figure 1, Columns of the Banking Union, showing the third pillar 'in development”

It should be noted right away that from the very beginning of the idea of ​​the Banking Union; there was no plan for a complete solution for its third pillar. Political dynamics demanded a step-by-step approach, the main factor being Germany's opposition and its constant fear of a situation in which would de facto become the main "financier” of the Eurozone. Former chief economist of the German Federal Ministry of Finance had voiced his concerns, saying that “EDIS would mean that the other countries would soon be liable for the consequences of misguided domestic policies, without those countries being able to influence such behavior.” (Agbonlagor, 2015). Bearing in mind Germany’s experience with the unintended and/or undesired consequences of integrative processes and the functionalist logic of expanding the competencies of joint institutions, its reluctance towards further centralizing of economic management on the European level is not surprising (Ash, 2012). Despite the ambitious plans of European officials and constant calls for reform (Valero, 2023) supported by the advice of economists, one of them being the Leibniz Institute for Financial Research SAFE (Krahnen, 2023), the guarantee of bank deposits remains a national competence. The rules in this domain have been harmonized through the Directive on Deposit Guarantee Schemes (Directive 2014/49/EU – Deposit guarantee schemes). This directive harmonizes rules related to the guarantee of bank deposits, aiming to provide a standardized approach across member states while acknowledging the national competence in this domain. The Directive outlines specific requirements and procedures for member states to ensure the effectiveness of deposit guarantee schemes within their jurisdictions. These rules encompass the scope of coverage, the maximum coverage amount per depositor, the funding and financing of deposit guarantee schemes, and the coordination mechanisms for cross-border situations. By elaborating on these rules, the Directive sets the parameters for how each member state manages and safeguards bank deposits, reflecting the prevailing nation-centric approach in the absence of a fully realized Banking Union pillar. This framework underlines the complexities and challenges associated with achieving a comprehensive and centralized European solution for deposit insurance.

DGS is surely the ground to build on, not something to get rid of completely – however, the issue with not revising it is that large local shocks cannot be fully supported; the failure of a system involving several banks can severely scar the DGS scheme. EDIS instead, gives a signal of confidence – it is surpassing the national guarantor, and it has the potential to solidify the role of the first two pillars.

To further strengthen deposit guarantees and financial stability in the Eurozone, the Commission then presented the European plan - the European Deposit Insurance Scheme (2015); it envisages equal treatment of member countries, regardless of their development, size, and sophistication of the banking system and the specifics of national deposit insurance systems, bringing the convergence to its peak.

Figure 2, Comparison of National DGS and Supranational EDIS

It is proposed to be implemented in three development phases from 2017-2024 (European Parliament and Council, 2015).

It would gradually move from the reinsurance phase, in which the European Deposit Insurance Mechanism would approve liquid support for national insurance schemes (under strict conditions and only up to a certain level), to the co-insurance phase, which means the progressive mutualization (pooling) of obligations in the aim of minimizing moral hazard, in which the European mechanism would bear part of the losses in case of payment of deposits, to finally reach the stage of full insurance of deposits at the European level.

Figure 3, Phases of EDIS Implementation

Financing of the EDIS would be done from the already established contribution rates of the banks participating in the national schemes by progressively increasing the part of this contribution that is transferred to the European Scheme, so that from the third stage all payments will be directed to a single fund. Therefore, the plan envisages the establishment of a joint fund that would transfer the risk of deposit coverage entirely to the European level – covering 0.80% of all deposits in Europe in 2024.

Figure 4, Accumulation of funds in the EDIS (% of covered deposits)

However, the member states have not, since 2012, managed to agree on the introduction of the EDIS, that is, the clear assumption of supranational responsibility for deposits. It seemed that a political breakthrough was made at the end of 2019 when the German finance minister announced that his country was ready to support a watered-down version of the European scheme's proposal (hybrid model taking place only when national DGSs run out of money) in the form of a national deposit guarantee reinsurance scheme, but this rhetoric does not cover all of the needed aspects for the third column of the European Banking System. (Valero, 2019)

The usual concern with common risk sharing is that it can create incentives fostering risk-taking behavior, and blame-shifting among countries. However, the absence of such a framework can prompt a vicious circle with a destabilizing feedback loop. The absence of a common risk-sharing framework, notably the lack of the European Deposit Insurance Scheme (EDIS), unleashes a pernicious feedback loop within the European Union, amplifying economic challenges. When member states hesitate to provide adequate fiscal support to their corporate sectors during downturns, tax revenues dwindle, impairing their capacity to navigate economic difficulties effectively. This financial strain on the corporate sector results in a surge of Non-Performing Loans (NPLs) held by banks. Faced with stricter credit requirements and increased instability, banks become a destabilizing force, eroding confidence in the financial system and jeopardizing the recovery of member states. In contrast, the implementation of common risk-sharing mechanisms would entail costs but these costs pale in comparison to the destabilizing repercussions of the feedback loop. The costs of risk sharing, such as potential moral hazard and blame-shifting, must be weighed against the debilitating impact of the loop, emphasizing the urgency of a comprehensive and shared approach to risk management within the European Union. Inaction risks prolonged economic instability and a deeper crisis, underscoring the imperative for a proactive and collective response.

Figure 5, Destabilizing feedback loop

"Once all parts of the banking union are in place, it will be up to the banks to explore and take advantage of the European market. Only then can it be determined whether the banking union has fulfilled its promises.” (Nouy, 2017). This kind of rhetoric has become established among Brussels bureaucrats and best illustrates the power and relevance of the ideas of the European "founding fathers" (Schuman, Adenauer, and de Gasperi) about "a Europe that will not be built all at once", but gradually through concrete achievements.

Therefore, the ceterum censeo and imperative is EDIS. Until then, Europe should not deem the work on the first two pillars finished but instead aim to solidify them with the complete Banking Union in mind and introduce new tools (such as stronger resolution transfer tools) with targeted changes. The current review of the CMDI allows such actions to be taken. But the EU ultimately needs the third pillar. Unarguably, the Euro is the Euro both in times of crisis and prosperity, both in Germany and Italy (and anywhere else), and it should function as such – fully and truly European.

References

Agbonlahor, W. (2015, March 10). 'Q&A: Dr. Ludger Schuknecht, Ministry of Finance, Germany.' Global Government Forum. [Online] Available at: Link 

Ash, T. G. (2012). 'The Crisis of Europe: How the Union Came Together and Why It’s Falling Apart.' Foreign Affairs, 91(5), 2–15. [Online] Available at: Link

European Central Bank. (2022, April 26). Example of Banco Popolar, and stress tests that show the resilience of the European banking system. [Online] Available at:  Link

European Parliament and Council. (2015). 'Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Regulation (EU) 806/2014 in order to establish a European Deposit Insurance Scheme.' COM/2015/0586 final - 2015/0270 (COD)

Nouy, D. (2017, September 29). 'Statement by Danièle Nouy, Chair of the Supervisory Board of the ECB, at the Single Resolution Board Conference.' Brussels. [Online] Available at: Link

Krahnen, J. P., & Tröger, T. (2023, April 17). 'Review of Europe’s deposit insurance framework: harmonization is not enough.' SAFE Finance Blog. [Online] Available at: Link

Valero, J. (2019, November 8). 'German plan brings ‘new impetus’ to banking union, Eurogroup says.' EURACTIV. [Online] Available at: Link

Valero, J., & Arons, S. (2023, April 12). 'EU Proposes Using Deposit Insurance to Wind Down Smaller Banks.' Bloomberg. [Online] Available at: Link