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A banking union to pool all risks

Published in Business Spectator (Melbourne), 7 December 2015

euro-notes-coinsImagine you lived in the middle of a dry desert and people from the coastal lowlands approached you with an ingenious proposal: to join their new flood insurance scheme. Unless you are very altruistic or insane, you would politely decline the offer.

A similar logic is at play in the EU Commission’s proposal to create a European deposit insurance scheme. If Brussels gets its way, banks from all eurozone member states will enjoy the same degree of deposit protection – and they will all need to pay into a joint fund to guarantee their customers’ savings.

There is only one problem with this idea: Why would anyone from a stronger banking system voluntarily want to pool their resources with, say, Greek or Cypriot banks? Indeed why would anyone allow the creation of such a new moral hazard? Is there not enough moral hazard in the eurozone already?

In defence of the European Commission’s proposal, there is at least a plausible rationale behind it. The idea is to strengthen European banking systems by decoupling them from their respective host countries. So far the refinancing costs of a bank are to a degree dependent on the fiscal conditions of the country in which it operates. Besides, the credibility of national deposit protection schemes also depends on the solvency of national governments.

To decouple banks from their governments, it would be useful to institute some kind of supra-national banking arrangements.

The European Union has already taken two significant steps towards this goal under the headline of “Banking Union”. Banking supervision now lies with the European Central Bank, and there is a scheme to wind up insolvent banks in Europe.

What is missing so far is a joint deposit insurance mechanism. It is the third pillar of Europe’s banking union.

The Commission’s plans would see deposits of up to Euro 100,000 jointly guaranteed by all eurozone member states from 2024. Until then, existing national deposit protection schemes shall be gradually merged into an EU fund.

In theory, the proposal would not only decouple banks and countries. It might even increase competition in the banking sector. If all deposits across the eurozone were equally protected, savers could take their money wherever it yielded the highest interest.

In practice, and after the experiences made in the long eurozone crisis, would anyone trust such a promise? Is it really that likely that, say, Dutch savers would take their euros to Maltese or Slovenian online banks in order to gain a marginally higher interest rate?

If there is one lesson from the eurozone crisis, it is that European rules can be amended, bent or ignored when push comes to shove. In an emergency, you would be best advised not to rely too much on any promises given earlier.

Defenders of European plans to centralise deposit protection might also point out that national deposit protection schemes put the European Central Bank in an unenviable position.

National insurance schemes are only as strong as the national governments that guarantee them. Once a country gets into trouble, it will be left to the ECB to not only keep these governments afloat but also their banking systems. Technically speaking, the ECB has no mandate for either – but it cannot easily walk away from this responsibility without risking to plunge a country into chaos.

So at least it is understandable why Brussels is pushing for European deposit protection. A few arguments could well be made for such a step towards the completion of banking union.

However, significant drawbacks remain and the most serious of them is moral hazard. As long as national governments have to fear being called in to bail out depositors in national banks, they will pay more attention to these banks remaining solvent. However, once the risks of banking failure can be passed on to a supranational fund, national governments might interpret this as invitation to behave recklessly.

And then there is the political problem sketched at the outset. Obviously, bank customers face very different risks across Europe at the moment. A Euro deposited with a German savings bank is probably safer than the same Euro in a Greek bank account. How much safer was on display when Greece was forced to introduce capital controls in the middle of this year.

Unsurprisingly, therefore, German banks are vehemently opposed to introducing common deposit insurance. To them, it feels like pooling their low risks with other banking systems that look a lot shakier. The fear is that through the vehicle of European banking union, German savers could eventually be asked to bail out other European banks.

Not only are German banks more stable than Greek banks. Germany already has a number of adequately funded deposit protection schemes whereas some other eurozone members have none. Again, the question is whether Germany has anything to gain from moving towards Europe-wide deposit protection. In all honesty, the other probably has to be “not much”.

German banks, assisted by their federal government, are thus resisting Brussels’ new scheme. Berlin has even threatened to organise a veto against the Commission’s plans. And who could blame the Germans?

Monetary union for Europe has always been a folly. To make this first folly a bit more workable, so it seems, another folly may be necessary. That other folly is banking union and the pooling of disparate risks.

It could take a while until European leaders recognise that the answer to the failings of European integration does not always have to be even more integration.

It is obvious that the EU’s banking union will eventually turn out to be a transfer union. It means that stronger banking systems will first guarantee and then pay for weaker banking systems.

You would indeed need to be altruistic or insane to find this prospect appealing.

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