Wanted: EU banking union as Cyprus kills off deposit-insurance dream
Euromoney, is part of the Delinian Group, Delinian Limited, 4 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 00954730
Copyright © Delinian Limited and its affiliated companies 2023
Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement

Wanted: EU banking union as Cyprus kills off deposit-insurance dream

The Cyprus bailout crisis lays bare the clear need for an EU banking union. Nevertheless, the eurozone’s single market will remain incomplete in the likely absence of an EU-wide common deposit scheme, with the solvency of national deposit guarantee schemes irrevocably tied to that of the sovereign.

On Tuesday, Commissioner Michel Barnier touted the trilogue agreement on creation of a single supervisory mechanism for the eurozone as “a first fundamental step towards a real banking union which must restore confidence in the eurozone's banks and ensure the solidity and reliability of the banking sector”.

Barnier insists: “This will contribute to strengthening the single market and to guaranteeing financial stability.”

But no one in the markets was paying much attention to this grand talk, with all eyes on Cyprus, where the botched bailoutreveals the glaring absence of a properly funded Europe-wide deposit guarantee fund. This would be the true mark of a real banking union. But that now looks like a dream that will never come true.

The market tremors from the much-maligned attempts to bail out Cyprus – an economy that represents just 0.2% of the EU’s GDP – will reverberate for years to come. The proposal to impose a tax on insured retail depositors in Cyprus violates creditor-hierarchy norms. 

 Protesters in Cyprus. Source: Reuters

Although consensus opinion decrees there is no imminent risk of depositor flight in neighbouring eurozone countries, a cloud of uncertainty now hovers over banks’ funding and capital structures at a time of economic and political distress. After all, the proposal undermines the sanctity of insured deposits, touted as the preferred funding source for banks over more flighty wholesale debt.

How flighty will retail and corporate deposits be in future, now that it’s clear that depositors are just another class of creditors to banks that face losses when there are no bondholders to haircut? Meanwhile, speculation mounts that the bail-in of senior bondholders could also be on the cardssooner than expected in similar instances of bank problems. But that’s not the biggest consequence of the tentative Cyprus bailout plan, which unravelled on Tuesday amid domestic opposition. At its core, it highlights the fundamental flaws in the EU’s plan to improve the eurozone’s economic architecture, which has been touted by some as the crisis circuit-breaker, in conjunction with ECB support.

Put simply, the lesson from Cyprus: the prospective EU banking union is unlikely to be backed up by an EU-wide deposit insurance scheme even as fears grow over the stability of bank deposits. (The other lesson: Germany’s desire to ensure losses are not socialized across EU borders is particularly apparent in an election year.)

As Euromoney has reported, the idea appears to have been quietly dropped amid German resistance, even as the IMF continues to argue a common deposit scheme is a pre-requisite, or at least an essential component, of a viable banking union.

Zsolt Darvas, researcher at European think-tank Bruegel, tells Euromoney: “I now don’t see any prospect of a eurozone guarantee scheme. Policymakers have clearly taken the view that a functioning banking union can take place without it,” citing the asymmetric cost-sharing between north and south Europe for the financing of any deposit guarantee scheme at the EU level, as the Cyprus saga lays bare.

The Bank Recovery and Resolution (BRR) directive was proposed by the Commission in June 2012 and policymakers insist it will be adopted this summer, to be followed by the Single Resolution Mechanism – the second major plank of the European Union's banking union project– which would transfer all responsibilities and powers for the authorization and prudential supervision of the large banks in the euro area to the ECB.

In the words of the IMF: “Moving responsibility for potential financial support and bank supervision to a shared level can reduce fragmentation of financial markets, stem deposit flight, and weaken the vicious loop of rising sovereign and bank borrowing costs.”


One of the aims of the BRR directive is ostensibly to protect depositors by boosting confidence in the integrity of the banking system. Even after the troika-backed Cyprus bailout proposal implicitly conceded that a euro in a peripheral bank account has potentially less value than a euro in a bank account in northern Europe, policymakers are banking that faith in eurozone bank-recovery and resolution can be achieved in the forthcoming directive without the existence of a common deposit insurance regime.

Crucially, Darvas says this hole in the heart of the EU’s institutional architecturewill remain in the long-term, rejecting suggestions the absence of this backstop also reflects a desire to separate fiscal and bank-recapitalization demands in the short-term from the longer-term need to reshape the EU’s fiscal design.

While the final outcome of the Cyprus bailout remains uncertain as the original deal is renegotiated, the fact the ECB, IMF and eurozone finance ministers took the decision to tax insured depositors – exposing the worthlessness of a deposit guarantee from a bankrupt sovereign – means a taboo has been irrevocably broken.

As a result, even if the EU wanted to beef up depositor insurance confidence, it might now be too late. “The US created its deposit insurance scheme in the 1930s to restore confidence at a time that deposits looked seriously at risk,” Nomura analysts say. "The euro area might have lost the opportunity to create such a guarantee scheme at the regional level for a long time."

Does this mean the banking union is already holed below the water line? Perhaps not.

Darvas remains optimistic about the EU’s financial integration efforts. He says the ECB, as the prospective single supervisory body, would have been able to prevent the high dependence of Cypriot banks on offshore capital and their unsustainable purchases of Greek government debt, with the Greek PSI costing them €4.5 billion, or 25% of Cypriot GDP.

In addition, the incoming resolution regime – with harmonized bank-bankruptcy norms across the EU – would have introduced clarity over the manner that Cypriot banks should be wound down and the relative assumption of losses between bondholders and uninsured depositors, boosting confidence among insured depositors.

Says Darvas: “The ECB would been an all-powerful supervisor in Cyprus’s case, reducing the scope for supervisory forbearance, with much more effective intervention at an early stage, and before the collapse of the banking system itself. In general, the eurozone banking union can proceed efficiently without a common deposit guarantee scheme.”

However, the eurozone’s single market will remain incomplete in the absence of an EU-wide common deposit scheme, with the solvency of national deposit guarantee schemes tied to that of the sovereign.

Tortuous negotiations on financial burden-sharing in the event of a systemic banking crisis in a eurozone economy will continue to imperil regional stability, with or without the banking union in its proposed form.