Breaking the direct link between eurozone countries and their banking systems is the major goal of the European banking union. But the risks borne by governments and banks continue to be closely connected, as recent events in Italy have shown. Two key elements of the banking union are still missing: a European deposit insurance scheme and a system of regulation for banks’ sovereign exposures. Unfortunately, the political situation in Italy could slow down eurozone reform. But allowing that to happen would be a big mistake. The deposit guarantee programme was at least mentioned in the final statement that emerged from the EU summit in June. This was surprising because it is one of the most controversial issues relating to banking union, especially in Germany. The strong opposition to it there is mostly the result of the lobbying of German banking associations, who have managed to establish the misleading narrative that such a scheme would misuse the money of German savers to rescue European banks. The truth is that existing deposit insurance schemes give banks in Germany a competitive advantage that they are reluctant to give up. Credible deposit insurance is crucial for financial stability.
Depositors in more solvent countries in practice enjoy better insurance and higher financial stability than depositors in less solvent countries. But in a currency union, instability in one country is likely to spill over to others. This is what we saw during the eurozone crisis that began in 2010. A well designed European deposit insurance scheme would help to break the vicious circle of bank and sovereign risk. It would reduce the need for government intervention through the bundling of funds within the eurozone and decouple deposit insurance from the solvency of any single country. It would also foster financial integration by allowing customers to choose more freely among banks across the eurozone as a whole, without forgoing high-quality deposit protection. Cross-border bank mergers would also be encouraged under such a scheme. This would improve risk-sharing, since domestic shocks could be buffered more easily by pan-European banks.
The benefits for the eurozone as a whole, as well as for individual savers in eurozone countries, would be considerable. There is a connection here to a more contentious issue: the regulation of banks’ sovereign exposures. Currently, this benefits from regulatory privileges, being exempt from capital requirements and large exposure limits. The result is high volumes of sovereign debt on banks’ balance sheets, with a strong bias towards domestic bonds. Under the deposit insurance scheme, sovereign default risks would be shifted to the European level. But despite its importance, the regulation of sovereign exposures is not on the political agenda. The European Commission has kicked it into the long grass. And the issue is not mentioned in either the June summit statement or the letter sent just before that meeting by
Mário Centeno, head of the eurogroup, to Donald Tusk, president of the European Council. The reason seems to be that regulation is unpopular in highly indebted countries. Their governments do not want to give up the stabilising role played by domestic banks purchasing sovereign bonds in times of crisis, even though this carries large risks for the entire eurozone. Even in countries such as Germany, enthusiasm is limited, given that state-owned banks in particular are loaded with sovereign debt. It is up to the European Commission to shift this important issue to the top of the agenda. The lukewarm support for Europe’s deposit guarantee system and the neglect of the issue of sovereign exposures are causes for concern. As the turmoil in Italy has reminded us, the eurozone remains fragile. Without cutting the cord between sovereigns and banks, the so-called sovereign-bank doom loop, completion of the banking union is impossible. A fiscal backstop for the single resolution fund, the EU’s rescue fund for failing lenders, and rules covering non-performing loans are not sufficient. Worries about Italy have led some to reject any further risk-sharing in the eurozone. But political instability there shows that action is urgently needed. To protect financial stability, the eurozone should offer more risk-sharing through common deposit insurance. But it should also inject more market discipline through the regulation of sovereign exposures.