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The Perils of European Deposit Insurance

The European Commission and the European Central Bank are wrong to advocate a Europe-wide deposit insurance scheme. While some form of deposit insurance is not a bad idea, a one-size-fits-all state-provided solution would do more harm than good.

MUNICH – Discussions are now underway to establish a system of joint deposit insurance for eurozone banks. Proponents of the scheme, with the European Commission and the European Central Bank (ECB) taking the lead, point out that deposit insurance would avert the danger of a run on banks in times of crisis. While this argument is true, critics emphasize the disparity in risks, owing to the high share of bad loans on the balance sheets of banks in some countries.

To address this risk disparity and move ahead with the plan, balance sheets will need to be cleaned up before considering the next step. While the share of bad loans for banks in the stable eurozone countries is just 2%, the most recently published International Monetary Fund statistics, from last April, show a share of 11% for Ireland, 16% for Italy, 40% for Cyprus, and 46% for Greece.

But this asymmetry is not even the main problem with the proposal. First and foremost, deposit insurance would induce irresponsible risk-taking on the part of banks. It would enable even the eurozone’s zombie banks to obtain savings deposits at will and use them to finance trash ventures worldwide.

Prior to their collapse in 2013, banks in Cyprus had to pay interest of 4% or more on deposits to compensate for savers’ fears of insolvency. Now just imagine savers bringing their savings to Cyprus and not having to worry about losing them, thanks to a European deposit insurance. Banks in Cyprus would be able to collect any amount of customer funds from anywhere in Europe by offering minimal risk premiums, allowing them to spin an even bigger wheel of fortune than they did in the past.

Some argue that this danger no longer exists, because the ECB is now supervising European banks. That is wishful thinking: no banking regulator will be able to prevent excessive risk-taking once a deposit insurance has been established. The banks won’t behave much differently from the states that failed to adhere to their debt limits after the ECB reduced interest-rate spreads by means of its program of so-called outright monetary transactions.

At least two recent examples illustrate the potentially devastating effects of collective mechanisms for protecting savers despite a joint banking regulator.

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One is the US savings and loan crisis of the 1980s. Protected by deposit insurance, US savings and loan institutions were able to attract, at low interest rates, huge amounts of customer deposits, which they invested in risky, though seemingly profitable, assets. The money was put in high-interest junk bonds, and there was a breathtaking maturity transformation: short-term maturity savings were transformed into long-term high-interest loans.

When these bets failed, the Federal Deposit Insurance Corporation stepped in. Well over 1,000, and probably closer to 2,000, S&Ls went bankrupt – about half of all savings banks – at a combined cost of $150 billion, of which the FDIC had to pick up $125 billion. The official report of a congressional commission of inquiry, released in 1993, found that it was in fact the joint deposit insurance that had prompted the banks to take these gambles.

The second example involves Germany’s state-owned Landesbanken (regional banks), which, protected by official guarantees, were able to take on debt cheaply and plowed the money into high-risk investment opportunities worldwide. When the Asian crisis peaked in 1997 and Russia declared bankruptcy the following year, Germany’s Landesbanken lost billions, and German taxpayers ultimately picked up the tab.

The fact that the Landesbanken later spun the wheel again – and failed again – when they were granted a grace period after the state guarantee was withdrawn, deserves only a brief mention here. After all, the Landesbanken had already become zombie banks before that, in the normal course of business, because of the depositor and investor protection afforded by the state’s guarantee.

None of this means that there should not be some form of deposit insurance. It only means that an expansive European deposit-insurance scheme should not be established even after the bad loans now on banks’ books are cleaned up. Why not leave it up to the banks to form mutually supportive groups? In Germany, for example, there are now four different deposit insurance systems.

This would avoid the over-emphasis on risk-sharing and the underestimation of behavioral risks inherent in state-provided solutions. A single, one-size-fits-all solution, such as what the EU Commission and the ECB are pursuing, amounts to an attempt to fight Europe’s smoldering bank fires with gasoline.

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