The Road To Eurozone Deposit Insurance

by: Martin Lowy

Creating a eurozone banking authority, a eurozone deposit insurance program, and a eurozone bank resolution system for the largest eurozone banks would not be the hardest design job in the history of public policy - if you knew what you wanted to accomplish. Unfortunately, Europe's politicians probably either do not know what they want to accomplish or disagree on their goals. At this point, it would be fruitless to try to guess where they all will end up. See here and here for recent articles on the subject. But as my friends at Shareholders Unite have observed, establishing a road map for such a system would be an important step. I recommend this article, if you have not read it.

I will sketch out the goals of a deposit insurance system, as seen by a non-European, then will sketch out the basics of the system one would put in place to get there fairly quickly.

The goals:

1. A deposit insurance system that is paid for by the banks (with the governments as backstops) that covers deposits up to 100,000 euros in any insured bank (as well as, with no maximum, payments system deposits that earn no interest) and pays off only in euros no matter what other currency anyone else adopts. There is no insurance for a deposit in any other currency. This system does several things: It deters capital flight, since a euro is a euro wherever it may be deposited. It protects retail depositors and the payments system. And it makes the financial system as a whole liable for the deposit insurance system's losses.

2. A single regulator/supervisor for all large eurozone banks.

3. A resolution system under which the regulator/supervisor can declare any large eurozone bank to have failed and to institute procedures under which the losses are borne first by stockholders, second by non-depositor creditors as their interests may appear, then by uninsured depositors, and only after that by the deposit insurance system.

The Deposit Insurance System

The U.S. deposit insurance system is a good model. It has been tested and, by and large, it works. If I understand the Treaties correctly, a zone-wide deposit insurance system could be established without Treaty changes. The problem is that some of the governments do not, quite understandably, want to stand behind a deposit insurance system that has little money and that will insure banks whose solvency may be doubtful. The solutions to these problems are simple in concept: Assuming a resolution mechanism that puts the deposit insurance system at less risk than other participants in a failure (shareholders and creditors), the ECB could grant a line of credit to the deposit insurance fund (which could be set up as a bank and therefore be eligible). The loans would be repaid out of sales of assets of the failed bank, and if that were insufficient, out of future deposit insurance premiums paid by insured banks. The risk that the ECB would not be repaid (which could happen if too many big banks failed) would be spread but it would not be on any nation's balance sheet.

The deposit insurance system's losses should not be enormous if the resolutions are accomplished properly, although efficient resolutions might require bridge funding from the ECB. The FDIC and the Federal Reserve did this as far back as 1974 in the Franklin National Bank failure, where the Fed has advanced $1.7 billion (which we thought was money in those days) to Franklin and did not call the loan when Franklin failed. The Fed was repaid out of the sales of collateral and the FDIC did not suffer any loss on the Fed's loans.

In addition, as part of the transitional architecture, no bank would be permitted to enter the deposit insurance system unless it was deemed to be in compliance with Basel 2.5 (and later, Basel 3) capital standards. If the ECB was given power to lend to the insurance fund, as I have suggested, then the ECB should have to make this determination, regardless of whether it is the regulator/supervisor. A large bank that did not meet the applicable standard would be required to do within a short period of time. Failure to do so would be cause for the bank's board and management to be replaced.

In my view, the deposit insurance system is the key ingredient in deterring capital flight because it would insure only in euros. Therefore even if a nation re-instituted its own currency, it would be deterred from changing the currency of bank deposits because they would lose insurance if the currency were altered. The deposit insurance fund even could have the right to seize a bank if its sovereign purported to change the currency in which its deposits were denominated.

But it is clear that deposit insurance cannot be instituted without a zone-wide regulator/supervisor to protect the insurance fund and a zone-wide resolution scheme designed to do the same. These ingredients are necessary conditions for establishing an insurance fund because without them, the fund could quickly be depleted, which both would prevent the stronger countries from endorsing it and would not convince the capital markets that it could succeed.

Not all banks would have to be in the new deposit insurance program. All banks over a certain size would have be covered in order (1) to have a sufficient fund, (2) to avoid adverse selection, and (3) to avoid regulatory arbitrage. But below the specified size, banks could be permitted to opt in, subject to an examination into their strength. Strong banks likely would opt in; weak ones would try to get stronger because remaining out likely would become regarded as a sign of weakness, unless nations were imprudent enough to snatch defeat from the jaws of victory by guaranteeing their non-deposit liabilities. Given the strange recent history of European bank bailouts, perhaps nations would have to be prohibited from bailing out their banks.

The Regulator/Supervisor

The identity of the supervisor is less important than most people believe. I say this because the supervisor has less real power than generally supposed, except when a bank is in extremis. And at that time, the major issue is when to close it. For this reason, the supervisor should have as its first goal the protection of the deposit insurance system.

Supervisors usually are saddled with conflicting goals. This is especially true of central banks, which often conduct monetary policy through the banking system and therefore rely on the banks to make loans that translate monetary policy into economic growth. It is not possible for a central bank to ride both the horse of protecting the deposit insurance system and the pro-credit horse of today's conventional central bank. Such a balancing act naturally will lead to political pressure to promote growth through increased credit, eventually to the detriment of the deposit insurance fund. (I would note that the U.S. Federal Reserve has been an indifferent bank supervisor. It always wants the power but seldom exercises it when the chips are down.)

For these reasons, I would opt to use the European Banking Authority, even though it is based in London and the U.K. banks would not (at least initially) be part of the deposit insurance program. The EBA is not an ideal supervisor, since it is new and would have less extensive oversight of some banks than others. Nevertheless, it might be less subject to national politics than alternative institutions and could attract the necessary talent to London (or poach from the U.K. authorities).

It is true that myriad laws or regulations would have to be put in place in order for a supervisor to have powers and the banks to have enforceable limitations. But if we take a page from the American "dual banking system", it is possible for the powers of a bank to be set by a nation (a state in the case of the U.S.) but for the major supervision to be accomplished by the deposit insurer or other federal regulator. That system is not ideal, but as a transitional matter, it is workable, and it would save a great deal of time.

Bank Remediation

Probably the most controversial piece of this puzzle is the bank remediation system and rules.

Europe has a recent history of protecting bank creditors at the expense of national treasuries. Ireland is the most extreme case, but all over Europe bailouts have been costly, perhaps totaling as much as four trillion euros since 2008. That is an incredible amount of subsidy to bank creditors and is, quite possibly, a significant cause of Europe's current recession and sovereign debt problem. Are the Europeans willing to treat bondholders as investors who take risks like other investors? Doing so might well cause bank funding costs - and therefore bank customer borrowing costs-to rise. But continuing the system of public subsidy looks kind of crazy in light of recent history, to say nothing of economic theory.

For these reasons, I will assume that it is politically possible to institute a bank remediation regime that forces not only stockholders but also bondholders to bear a large part-in some cases, all-of the loss when a bank fails. Under such a regime, the regulator declares the bank has failed and institutes an approved form of reorganization. In the U.S., that form of reorganization has been to sell the deposits and at least some of the bank's assets to another bank, topping up the assets with cash from the deposit insurance fund to the extent that the acceptable assets are not sufficient to match the sum of the deposits and whatever premium the buying bank can be induced to pay. This process generally includes an auction in which several banks bid for the failed bank through the premium they are willing to pay for deposits and the assets they are willing to absorb.

Large modern banks that have large derivatives businesses, complex corporate structures, and related insurance businesses pose challenges for regulators seeking the most efficient means of reorganization. Suffice it to say for purposes of this discussion that many detailed decisions have to be made in the course of creating the reorganization laws and regulations. A great deal of scholarship has focused on these issues in recent years, and therefore one could expect a resulting set of mechanisms that would work in the modern context, once the basic decision as to who must bear the losses has been made.

Nevertheless, designing this system may be the most time-consuming and contentious part of the process of creating a zone-wide deposit insurance fund.

A Safe, Liquid Instrument

I submit that there should be an additional Zone-wide ingredient: An instrument that is as safe and as liquid as possible that banks can use for their liquidity needs. The U.S. banking system has such a thing in the form of U.S. Treasury securities. Eurobonds that are guaranteed by all the nations of the Zone seem not to be politically feasible at this time. But why should the ECB not issue bonds that can be held solely by banks in the deposit insurance system? That is akin to the ECB taking banks' deposits, except that the ECB could use longer-term bond issuance to fund projects of similar duration and pay a better return than it pays on deposits.

I recognize that if banks park their liquidity with the ECB, they will not be supporting their local governments' borrowing needs. But longer-term, that circular system of mutual reliance should change anyway.

Impact on Banks and Investors

Banks that qualified for the zone-wide deposit insurance fund would be better investments for equity investors because they would have greater stability. They would be likely to take less risk and, therefore, to have more consistent earnings. If a zone-wide deposit insurance fund eventuates, I think that large banks such as Deutsche (NYSE:DB), Credit Agricole (OTCPK:CRARY) and Societe Generale (OTCPK:SCGLY) - but perhaps not banks in Spain and Italy that have large exposures to their sovereign debt-would become good buys at current prices as long as they did not have to dilute their shareholders in order to comply with capital requirements.

Large European banks also would become less politically connected because individual countries would gradually have less control over them. That would be good for European economies as well as their banks. A eurozone deposit insurance fund is not pie in the sky - and it will not solve all the eurozone's problems - but the transitional issues must be dealt with quite carefully.

Disclosure: I am long DB, OTCPK:CRARY, OTCPK:SCGLY.

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