European Banking Union in Crisis: Why EDIS is a Bad Idea (Brussels Morning)
Channel: Sam Vaknin's Musings
Date: 2023-05-18

Banks are the most unsafe institutions in the world. Worldwide, hundreds of them crash every few years. That banks are very risky is proven by the inordinate number of regulatory bodies which supervise banks and their activities.

As far as banking goes, the European Union is a heterogenous area with weaker, more vulnerable financial systems in the south and east. 

Introducing a European Insurance Deposit Insurance Scheme (EDIS) which draws on the national resources of Deposit Guarantee Schemes (DGSs) would penalize countries such as Germany and Austria.

This punitive disparity led to a stalemate. Even as other components of the envisaged European banking union – supervision (SSM) and resolution (SRM), most notably - have fallen into place, EDIS remains controversial.
 
At the heart of this conundrum is a debate about who should be left holding the can when banks fail: shareholders and creditors – or taxpayers and savers? The EU Commission leans towards the latter, to the evident displeasure of the more liquid, austere, and disciplined member countries.
 
The European banking union seeks to decouple banking risks from geography. Depositor confidence would no longer reflect the level of trust (or distrust) in local authorities. The EU will become a universal guarantor and shock absorber for banks of all sizes, drawing on the resources of national DGSs. 

This would be similar to the situation in federated entities such as the USA, Mexico, or the Russian Federation. But this is a superficial similarity. The EU is not nearly as homogeneous and centrally managed as the USA, either fiscally and monetarily. 

Many of the initiatives of the European banking union, such as the sovereign bond-backed securities (SBBS), make eminent sense.  But EDIS is an exception: it would have an adverse impact on the risk profile of banks in the EU and create moral hazard in many of its territories, especially in southern and eastern Europe.

Deposit insurance should be an instrument of last resort, after all legal steps have been exhausted to recover funds from shareholders and creditors. Even then, it behooves it to be limited. Every stakeholder in the banking system need to do their due diligence before they plunge into a relationship with a financial institution. 

Moreover: deposit insurance ought to reflect local risks and be responsive to idiosyncratic information about the profiles of depositors, lenders, borrowers, and intermediaries. 

Column in Brussels Morning: https://brusselsmorning.com/european-banking-union-in-crisis-why-edis-is-a-bad-idea/32314/

A Europe wide insurance scheme is liable to foster recklessness and engender deceitful practices in pockets of the industry, among specific types of lenders and borrowers, or at times of bubbly irrational exuberance. 

In short: EDIS may boost depositor confidence in the short-term, but as banking crises proliferate, it will come to be seen as liability among the more sober and responsible members of the Union. Such discontent can lead to a serious rupture in the solidarity of the banking sector as reified by institutions such as the ECB, SSM, and SRM. 

A better idea would be to group banks by size across the EU and create the EU-wide equivalents of the mutual deposit guarantee schemes among Volkbanks, Sparkassen, and Raiffeisenbanks in Germany and in Austria.

The industry must bear the brunt of its own miscalculations and misconduct. The only way to secure this outcome is to force banks with the same financial profile (e.g., small or medium-sized) across the entire area of the EU to forge together insurance schemes, replete with annual contributions.

These premiums payable by the member financial institutions will be based on the bank’s own unique risk profile, the risk profile of the bank’s domicile and of the geographical distribution of its operations (credit ratings), and the risk profile of the EU itself, i.e., the market risk (the equivalents of alpha and betas in portfolio management). 

The EU-wide schemes will spring into action only when relevant DGSs had failed. At no point will savers, depositors, or taxpayers be asked to foot the bill unless all the insurance schemes have exhausted their combined resources (a highly unlikely event).

Deposit insurance schemes should be allowed to issue and sell bonds (borrow) and to temporarily own equity and debt instruments of failing banks. In short: in some respects, they should function a lot like modern central banks.

EDIS is an antiquated concept which penalizes the virtuous to salvage the profligate and the reckless. This is not right – or sustainable in the long run.