Eurozone divorce: sizing up deposit outflow risk


Sid Verma
Published on:

Urgent steps are needed to craft an EU-deposit guarantee scheme that has teeth, analysts have said, as market attention turns to deposit outflow risk in peripheral Europe.

As market rumours swirl over Greece’s exchange-rate prospects, fears are growing that deposit outflows from the weaker eurozone economies will soon gather pace. In short, if Greece converts euro deposits into its own currency, the European Central Bank (ECB) might be forced to abruptly guarantee all deposits in eurozone banks similar to the Fed action after the Lehman disaster.

If you think policy efforts to unfreeze wholesale funding markets have been less than desirable, buckle up: the long-term refinancing operation (LTRO) was the easy part. Analysts at Goldman Sachs sized up the risk of deposit outflows in a research report on Tuesday, concluding: 

“Recent media reporting centres on potential customer deposit volatility at selected institutions on the periphery. The LTRO was not aimed – and would not be effective for – [at] potential volatility in customer deposit bases, in our view.

• The nine largest European banks – those under our coverage – report liquidity buffers of over €1 trillion, or some 28% of customer deposits (and 16% of their funded assets). Liquidity buffers are ample in our opinion.

• Still, liquidity buffers are effective when viability of a single institution is in question – they can serve to build confidence in the remaining “functioning” banks. If deposit loss occurs as a result of a systemic event, individual liquidity buffers would not prove effective in our view. Fears of a euro break-up (and fear of a corralito-type [the Argentinean-government deposit freeze in 2001]), for example, could give rise to loss of depositor confidence on a systemic level. This would call for a regulatory response.

• Typically, such a response would be at a government level. For the banks on the periphery where the stability of the sovereign is in doubt, it would need to be made at a multinational level. A pan-European deposit guarantee or a pan-European bank bailout facility would both work well for this purpose in our view."

So far, so sanguine.

As we have reported, the deposit outflow story in Greece is backed up by the official data, with a bleeding of the customer deposit base since end-2009. But elsewhere, volatility in customer deposit base is anecdotal – management at Bankia, Spain’s third-largest bank, for example, were forced to deny market reports that outflows have kicked in, although, according to ECB data, there was a marginal deposit loss in aggregate in the Spanish banking system in Q1 at 4.3% year-on-year. But a shift of deposits into money market products for some yield might account for a portion of this, according to Goldman. Italy, by contrast, has seen deposit inflows, Ireland and Portugal have held steady – while the Germanic banks have been the big winners, a symptom of intra-eurozone monetary imbalances.

However, the data available only relates to Q1 trends, and deposit outflow rumours might become self-fulfilling, cf. Northern Rock. Under the shadow of this risk, banks have a couple of beefy defences, according to Goldman Sachs: 

“Were a loss of confidence, followed by a larger deposit outflow to begin to materialize, the largest European banks could sustain a substantial shock to their customer base. Depending on the entity, between 25% and 35% of deposits could be lost. By way of comparison, the Greek banks have lost c.30% of their deposit base since the start of the sovereign crisis in 2009 (ie cumulatively, over the past three years). In other words, we estimate that the largest banks currently have sufficient liquidity buffers to absorb the cumulative deposit flight experienced by Greek banks since 2009.

• Finally, it is clear that a deposit run of a system-wide magnitude could not be absorbed by banks themselves – external intervention would be needed. "

In short, on the optimistic side, there is scant evidence of deposit outflows from peripheral European banking systems save for Greece and the bigger banks have sufficient liquidity buffers. But the downside is that  in the event of a systemic deposit outflow crisis, a pan-European response will be undermined by an EU deposit scheme that currently lacks teeth.

The deposit insurance scheme has two big drawbacks, according to Barclays Capital:

“The first is the local nature of the guarantee provider, which creates doubts about its ability to pay insurance claims; and the second is that this crisis is defined by emerging currency risk, which is something deposit insurance does not protect against. "

Go on:

“Historically, the deposit insurance landscape in the Europe Union reflected the varying degrees of strength and diverging priorities of individual member countries. The European Commission used to maintain a “minimum harmonisation” approach through its original Deposit Guarantee Scheme Directive (94/19/EC), but the financial crisis of 2008 highlighted some significant differences between the treatments of depositors within the 27 member states.

Specifically, deposit insurance limits diverged across Europe to the point that during 2008 and 2009, there was evidence that EU depositors were shifting their cash to member states that offered higher deposit protection and away from those offering less coverage. To offset this, the remodelled directive (2009/14/EC) was published in 2009. This sought to increase harmonisation and required member states to ensure a level of coverage that was fixed at €100,000 by the end of 2010. "

European policymakers, in other words, should take pay heed to the US’s powerful federal deposit guarantee scheme. The absence of clarity on this, of course, underscores the now-painfully obvious weaknesses in the eurozone’s political economy, including divergent bankruptcy codes across the monetary union and the stubborn lack of clarity over fiscal burden-sharing arrangements for bank bailouts.

Still, even if the bank deposit scheme is given EU-backed teeth, it presumably would fail to take into account currency redenomination risk. Expect this to be the elephant in the room at the Wednesday EU summit.