Why Europe's bank supervisor is hamstrung

The EU has released its proposal for a union-wide banking supervisory mechanism, but its failure to centralise deposit insurance simultaneously may be its undoing.

VoxEU.org

The European Commission has now presented its legislative proposal for a banking union whose key element is a ‘Single Supervisory Mechanism’ to be headed by the ECB, but it says nothing about deposit insurance at the national level. Is that viable?

Setting the incentives

Economists use a ‘backward’ approach when looking at the link between supervision and deposit insurance and resolution. The endgame of deposit insurance and resolution drives the incentives for ex ante supervision.

A key point here is that the purpose of good supervision is not to prevent banks from taking any risks and thus make sure that no bank ever fails. The purpose of good supervision is to equilibrate the relationship between risk and reward for the private sector, especially for bank managers and the owners of banks. Growth and innovation would be stifled if banks were not allowed to take any risk. With good supervision bankers and their investors would, however, be forced to accept the consequences if any risky investment goes awry – possibly up to the point that the bank has to be closed or restructured. This implies that there will still be bank failures even if the ECB were to do the best possible job as the supervisor of the eurozone’s banking system.

If depositors are guaranteed, they will no longer have an incentive to monitor the bank. Normally the supervisor then takes over the monitoring role representing the depositors. This is naturally the case at the national level, where both the supervisor and the deposit insurance system are part of the same government. But this would not be Europe if only supervision were centralised and national authorities remained responsible for deposit guarantee and restructuring. The ECB would have an incentive to offload the fiscal cost of any problem to these national authorities.

As long as deposit insurance and resolution were to remain at the national level serious conflicts would necessarily arise if the ECB thinks that any given bank needs to be restructured or closed down. The ECB would do this on the basis of its assessment of the viability of the bank and any danger it might represent to systemic stability at the eurozone level. By contrast the national deposit guarantee systems, and more generally the national authority responsible for bank restructuring (i.e. in practice today’s supervisors and finance ministries), would have a tendency to minimise their own costs by keeping the bank alive through support from the ECB. National authorities would have naturally a tendency to blame an ‘unfair’ ECB for not recognising the strength of ‘their’ bank which should not be closed, but saved. This type of conflict is likely to be especially prevalent at the start of the new system when the ECB has to discover all the skeletons in the closet hitherto hidden by national supervisors.

Over time other conflicts will arise. For example, if the ECB has made a mistake and let a bank take too much risk. National authorities would then have a point in complaining if they had to pay up for the costs.

The best way to avoid these potential conflicts and provide the new eurozone supervisor with proper incentives is to gradually move deposit insurance and resolution to the eurozone level as well, thus ensuring eventually the needed alignment of responsibilities. A gradual introduction would ensure that both national and EU-level authorities have ‘a skin in the game’ during the transition.

In the US, a two-tier system emerged with banks chartered at the state or federal level. In the end the smaller, state-chartered banks became less and less important. This analogy suggests a compromise: groups of smaller banks with their own mutual guarantee system (e.g. savings or mutual banks) might not fall under the direct supervision of the ECB, with national supervisors, who have a better local knowledge, remaining responsible for the day-to-day supervision of these banks.

However, a large group of small banks with a similar business model can also represent a danger for systemic stability. This implies that, the national supervisors would remain responsible towards the ECB for the systemic stability of these groups of banks and that the ECB should be given the right to require all the information required to assess the stability of these groups.

Systemic crisis: National versus eurozone

A standard objection against a common deposit insurance fund based on the FDIC model is that it would be too small to deal with systemic crisis. This is undoubtedly true for a systemic crisis at the EU or eurozone level. However, one should also ask the counter question: would the system be more stable with the existing patchwork of national schemes, only some of which are actually pre-funded? The answer must obviously be no. A common, prefunded, deposit insurance and resolution system could only improve the situation.

Moreover, in Europe real estate booms and other shocks will remain for some time concentrated at the national level. Systemic crises are thus more likely to arise at the national level than at eurozone level (Spain and Ireland provide vivid examples).

Recent IMF and World Bank studies find that the 'typical' fiscal cost of a crisis seems to be about 5 per cent of GDP. If one accepts this figure for the 'typical' fiscal cost of a crisis it follows that an EDIRA endowed with a fund of €50 billion should be sufficient to handle a 'typical' crisis for all smaller member countries (like Greece, Portugal or Ireland today) and possibly even for Spain with a GDP of €1,000 billion. Moreover, in case of a very large crisis the funding base of the EDIRA (the eurozone banking system) would be much stronger and more credible should the costs go above this figure.

For a systemic crisis at the eurozone level it would be a question of the ECB intervening anyway, because at that point the fiscal costs be too large for any mere deposit insurance scheme. Moreover the ESM, which in our mind would provide the ultimate fiscal backstop, would be able to deal with a ‘typical’ crisis even at the eurozone level (5 per cent of about €10,000 billion GDP for the eurozone is about equal to the €500 billion lending capacity of the ESM).

Moreover, an EDIRA would be able to considerably diminish the threat of deposit flight due to convertibility risk in any country subject to a financial crisis. Depositors in any country subject to a systemic crisis (at the national level) will ask themselves whether their deposits are safe given that the national deposit guarantee system will be too small to deal with the problem, and given that the government itself might experience financing difficulties. This means that national deposit insurance can do little to prevent national bank runs, much as in the US of the 1930s state guarantee systems could not prevent local-level bank runs.

The debate about Banking Union is running into the typical chicken-and-egg problem; Most academic observers agree that deposit guarantee and resolution should be organised at the same level as supervision. But at present only the creation of a ‘Single Supervisory Mechanism’ to be headed by the ECB is being discussed; with deposit insurance and resolution to be considered only later when this SSM has shown its effectiveness.

We argue that the SSM is unlikely to be working well unless a European Deposit Insurance and Resolution Agency is introduced gradually at the same time.

Originally published on www.VoxEU.org. Reproduced with permission.