Plans for a European deposit insurance scheme postponed ‒ important groundwork to be laid down soon

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  • On 16 June 2022, the Eurogroup agreed to divide the further development of the Banking Union into smaller steps.
  • The meeting started with four elements on the table: the crisis management of small and medium banks and the use of deposit guarantee funds to this end, a European deposit insurance scheme, the treatment of banks’ sovereign bond holdings, and the single market.
  • In the end, it was decided that only the first of the four – crisis resolution – would proceed at this point. A legislative proposal from the Commission is expected by the end of the year.
  • Finance Finland (FFI) is satisfied that the work will first focus on laying down the foundation and only then on building further from a solid standing point.

Finance Finland (FFI) is satisfied that the work on completing the Banking Union will first focus on laying down the foundation and only then on building further from a solid standing point. The chief purpose of establishing the Banking Union was to ensure that taxpayer money would no longer be needed to salvage failing banks. A viable system cannot involve loss transfer to national deposit guarantee schemes and further to other member states. Instead, the losses must be primarily carried by the failing bank’s investors. When developing the Banking Union and, potentially, a common deposit insurance scheme for the union, it is important to keep in mind what it is that this work is trying to accomplish and to what end.

“A poorly or carelessly designed banking union will not be of help in a potential banking crisis – instead, it will most likely make things worse. It is much better to build on rock, not sand”, says Olli Salmi, head of banking regulation at Finance Finland.

What makes for a solid foundation?

In spring 2021, Finance Finland proposed its own compromise model for the implementation of a European deposit insurance scheme. Finance Finland’s model emphasises a full-scale implementation of investor bail‑in so that taxpayers will not incur direct or indirect losses. Direct losses arise if taxpayers have to save a failing bank, and indirect losses arise if the losses are carried by the deposit insurance scheme, which is ultimately funded with money from the banks’ customers – that is to say, taxpayers.

“In Finance Finland’s model, the capital of the bank’s estate in bankruptcy will cover the protected deposits in all scenarios. The model is feasible because banks’ core equity capital, which mainly consists of investments by the bank’s owners, provides a good buffer for deposit protection. The amount and quality of core equity capital have been significantly increased after the financial crisis, and they are also intensively regulated and supervised. Banks also hold other debt investments that can be used to cover losses before drawing from deposits”, Salmi explains.

This protective buffer is not limitless, so it is important to break the loss spiral early enough. The banking supervisor’s capability and will to act in a timely manner are thus a vital prerequisite for the system to work. Capability here refers to supervisory measures and sufficient powers: first, to detect a bank’s crisis and second, to shut down the bank’s operations. It also includes the resolution authority’s powers to liquidate the bank’s assets.

“A poorly or carelessly implemented banking union would not be helpful in the event of a banking crisis – instead, it would make things worse. It is much better to build on rock, not sand.”

OLLI SALMI, Head of Banking Regulation

Will means that the liability mechanism incentivises the supervisor’s home state to place the failing bank into resolution and liquidation at an early enough stage. All previous and current EU plans have laid the responsibility for covering bank losses on the potential common deposit insurance scheme, which would remove the incentive from national supervisors to wind down the bank early enough.

“Why close down the bank if someone else will carry the losses anyway? Supervisors may also be under political pressure to put off the process. There is an obvious inherent risk of moral hazard in a common deposit insurance scheme that covers losses.”

To mitigate this risk, Finance Finland’s model emphasises the need to improve the efficiency of initiating and carrying out the wind-down of a failing bank. A main goal is to have the failing bank’s owners and investors bear the costs instead of taxpayers or other banks.

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Financial and Prudential Regulation

Olli Salmi

Head of Banking Regulation