Germany’s rejection of a pan-European deposit guarantee scheme is no disaster

By:
Sid Verma
Published on:

The Cyprus bailout could yield benefits if it galvanizes the push to appropriately finance and structure national deposit guarantee schemes in EU member states that have been dangerously neglected since the 90s.

Like a broken record, EU policymakers continually tout the eurozone’s fiscal and banking co-ordination efforts as the crucial circuit-breaker needed to reduce the negative sovereign-bank feedback loop. Sadly for them, no one is paying much attention.

In a report published on Thursday, Vítor Constâncio, ECB vice-president, noted: “In spite of the improvements in market conditions, the climate in the financial markets remains fragile. The level of fragmentation remains high in some markets, eg money markets.

“The improvement in financial conditions has not been reflected on the real side of the economy. Economic growth in Europe will be essential to complete the adjustment that took place.”

He added the kicker: “Therefore, it is of paramount importance that the momentum is maintained towards structural reforms at national level and towards building a stronger Economic and Monetary Union through European-level institutional reforms.

“Further progress towards the establishment of the banking union – SSM [single supervisory mechanism], SRM [single resolution mechanism] and harmonized DGS [deposit guarantee schemes] – will be a critical factor underpinning future growth and financial integration.”

It seems Angela Merkel, German chancellor, did not get the memo. With canny timing, also on Thursday, Merkel rejected “a unified European deposit insurance – at least for the foreseeable future”, highlighting the holes in the EU banking union plan and how the solvency of national deposit guarantees will remain exclusively tied to the sovereign, laying bare the financing risks of bank rescues in the periphery, and elsewhere.

The comments reflect Germany’s determination to dodge the financing bullet of legacy banking liabilities and instead engineer a correction of outsized and asset-poor banking systems in the periphery.

Analysts still expect that Germany is in favour of harmonizing the rules governing national DGSs, rather than mutualizing liabilities, in an EU directive that could kick in from 2015 at the earliest.

According to Barclays Capital, around two thirds of the eurozone’s €3 trillion deposits are covered by national guarantees. The stakes for depositors are now higher post-Cyprus which demonstrated both why a pan European, ie mutualized, DGS is highly desirable but also why it is highly unlikely.

The Cyprus bailout template signals the end of the post-Lehman settlement – that policymakers will rush to guarantee all depositors in return for market stability – a development that capped the interest rate differential offered for eurozone deposits above and below €100,000, the benchmark for national deposit guarantee insurance.

“One of the lessons from Cyprus is that uncovered depositors should think of themselves as senior unsecured creditors rather than depositors,” Barclays Capital analysts argued in a report earlier this month, estimating higher deposit rates could cost the eurozone banking sector around €8 billion annually, or 6% of its profit.

This extra burden, combined with the urgent need to finance national deposit guarantee schemes, plus a resolution fund, means the broader macro consequences of the Cyprus saga equate to a €15 billion annual reduction of eurozone banks’ profits, or 11% of the total, the analysts argue.

Other analysts – though accepting the fact that even insured depositors were deemed appropriate targets for a haircut by the troika in the initial bailout plan has undermined confidence – doubt the Cyprus package, or indeed Germany’s rejection of DGS mutualization, will trigger a large wave of deposit re-pricing and outflows from banks in the periphery.

Daniel Davies, banks analyst at Exane BNP Paribas, says the inherent stickiness of deposits and a lack of systemic deterioration in eurozone liquidity conditions subsequent to the bailout should nurture a degree of confidence in the systemic stability of eurozone deposits.

What’s more, in recent weeks, “momentum appears to be building to entrench uninsured depositor preference over bondholders in the upcoming EU directive”, along the lines of the US model, which would boost the stickiness of term deposits, says European banking analyst Miguel Angel Hernandez at Barclays Capital.

The Cyprus crisis then could yield some benefits: galvanizing the push to adequately finance existing national schemes at the individual country level, harmonizing eligibility criteria and coherently structuring such schemes in an ex-ante, rather than ex-post, fashion – as is the case in six out of the 27 EU schemes.

However, even if the Cyprus saga inflicts no-lasting damage to depositor confidence, EU policymakers and banks – faced with a higher DGS financing burden – still have a mountain to climb before the EU catches up with the capacity of the US FDIC to absorb multiple failures of smaller banks and prevent them from triggering systemic crisis.

A Barclays Capital report makes sober reading: “In almost all of Europe’s largest countries, the DGS either has no pre-funding [UK, Netherlands, Italy] or less than 20 basis points of pre-funding [France, Germany, Spain] ... For Europe as a whole, DGS balances are dramatically lower than in many other countries, and most importantly are less than half the 1.35% of insured deposits that US banks are mandated to get to by 2020, under the Dodd-Frank Act.”