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There’s one problem with a European deposit guarantee scheme: it won’t work

Deposit insurance schemes offer scant consolation amid systemic bank runs and currency redenomination fears.

In Brussels on Wednesday, José Manuel Durão Barroso, president of the European Commission, tried to calm fears about a euro break-up by laying out the building blocks to closer economic and monetary union, including “a banking union with integrated financial supervision and single deposit guarantee scheme” (DGS).

There has been little hard evidence of widespread deposit flightfrom the banking systems of peripheral eurozone countries likely to be hit hardest by the first wave of contagion from any Greek exit.

In the second half of 2011, before the European Central Bank (ECB) announced its three-year long-term refinancing operation, the deposits of the Spanish banking system fell by 3% and of the Italian system by 2%. In the first quarter of this year, deposits remained stable in the periphery and even increased, notably in Italy.

However, it is this dreaded prospect of bank deposit flight, even more than further dumping of sovereign bonds by foreign investors, that haunts the dreams of European policymakers.

The notion that a Europe-wide DGS might prevent such a dire outcome has grown in popularity in recent days. The hope is that a Europe-wide scheme would overcome depositor worries that a financially stressed sovereign might fail to meet its obligations under a national guarantee scheme.

The obvious problem, most analysts identify, is that it might take too long to implement such a scheme. That’s because it could require treaty changes to overcome the obvious objection that a jointly funded scheme would amount to monetary financing of weaker sovereigns by the stronger ones, assuming their contingent liabilities for national banking systems.

As things stand, there are considerable differences between national schemes. Some are pre-funded by charges to banks, typically as a percentage of customer deposits. Others are not. Most are designed to protect against the failure of one or two banks, not the failure of a national banking system. All ultimately depend on direct or implicit sovereign guarantee.

Lorenzo Bini Smaghi, a former ECB board member, tells Euromoney: “It’s technically feasible but the question is whether it is politically feasible and whether countries would be up for that since the funding would need to be shared. To some extent, the scheme requires a fiscal burden-sharing arrangement.”

However, there is a more fundamental drawback. The evidence suggests that deposit insurance schemes won’t protect against the feared risk of systemic bank runs.

Greece has a DGS, yet even as the country negotiated its bailout and debt forgiveness, and the ECB kept its banks propped up, Greek banks have lost a quarter of their deposits in the past two years. That’s because Greek depositors have two fears: banks collapsing, and a redenomination of their deposits into a new and very weak drachma.

DGSs protect depositors against loss in the event of bank failure but not in the event of redenomination. And it is this prospect that has spurred deposit flight from Greek banks and might beset the banking systems of other countries if Greece were to set the precedent of leaving the single currency.

Hard currency

Could a scheme be devised to protect against redenomination as well as failure? Analysts at Barclays suggest in a note published on Thursday: “The only way such a DGS could work is if deposits were guaranteed in euros even after countries have left the euro – with the risks of devaluation being transferred from depositors to the DGS provider.

“This could result in the bizarre situation of having [newly] non-eurozone countries having all their domestic deposits denominated in euros. Would such a scheme be credible?”

The implication is: almost certainly not. Barclays says: “Whilst this may be affordable vis-à-vis redenomination fears in Greece, Ireland and Portugal, it would lack credibility in a worst-case scenario of contagion spreading to Spainand Italy as well.”

That’s because the banking systems of those countries are so large. In addition, Spain has revealed some of the limitations of deposit insurance schemes. When the Spanish authorities upped the charges to Spanish banks for guaranteeing their deposits, many banks switched to raising retail funding through bonds issued through their branch networks. Depositors might not have been clear in every case over the difference between underlying protections on these bonds compared to deposits.

It’s also worth recalling what happened in Argentina in 2001, the most recent example of a country facing effective redenomination risk in the run up to abandonment of the dollar peg. Argentina’s DGS did nothing to prevent its citizens pulling their deposits from the banks, including 6% of the system’s deposits on one day in November and 20% for the whole of 2001. This led to the corralito, or freezing of deposits, at the end of the year.

The Barclays analysts conclude “whilst a euro DGS may initially sound appealing, it is probably an inappropriate tool to be used in isolation to manage down the contagion risks from a Greek exit”.



Source: BarCap