Banking: Redefining the Role of Deposit Guarantee Schemes in Europe
Shakeel Jeeroburkan ACSI
Senior Performance Operations Analyst at Fidelity - Masters in Investment Fund Administration Candidate - 1st Class Honours Financial Services Analytics (1.1) - 2023 Apprentice of the Year National Award Winner (Finance)
The European banking sector has confronted a myriad of challenges subsequent to the global financial crisis of 2007-2009, culminating in a comprehensive transformation of its regulatory landscape. Reflecting upon the recent United States experience, in which three bank failures since the commencement of the year have posed a contagion risk to the national economy, a pivotal aspect of this reformed framework is the management of small and medium-sized banks, integral to the stability of the European financial system. Here's an analysis of the current state of Deposit Guarantee Schemes (DGSs) within the European Union , along with a critical evaluation of the proposed modifications to their legal framework. The ultimate objective is to establish a standardised EU procedure that facilitates the effective management of banking crises.
DGSs: Current Role and Limitations
As it stands, the role of DGSs in the European banking landscape is limited. They primarily serve as a safety net for depositors, reimbursing them in the event of a bank failure. While this function is essential, the current legal framework does not allow DGSs to actively participate in the management of banking crises, nor does it provide them with the necessary tools to prevent or mitigate the impact of such crises.
One of the main challenges facing DGSs is the lack of clarity regarding their position in the Bank Recovery and Resolution Directive (BRRD), specifically whether DGS alternative interventions trigger the resolution of a bank. This ambiguity creates uncertainty, which can undermine the effectiveness of DGSs in times of crisis. Moreover, the current legal framework does not allow DGSs to rank pari passu with other depositors in national insolvency proceedings, which could lead to a suboptimal allocation of resources and a lack of equal treatment for all stakeholders.
The Need for a Standardised EU Framework
To address these limitations, the authors of the analysis propose a three-pronged approach:?
Achieving these goals would require a limited number of amendments to the current legal framework, but their potential impact is significant. By empowering DGSs to actively participate in the management of banking crises, the proposed changes would create a more resilient and efficient financial system in the EU.
Moreover, a flexible application of the "least cost principle" would ensure consistency with the broader objective of limiting state interventions, while a clarification of the State aid regime would ensure a level playing field between private and public DGSs in Europe.
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Critique and Recommendations
While the proposed amendments to the legal framework are commendable, they are not without potential pitfalls. For instance, the suggestion that DGSs should rank pari passu with other depositors could lead to conflicts of interest, as depositors may not always share the same objectives as DGSs during a banking crisis.
Additionally, the proposed changes could inadvertently create moral hazard. By allowing DGSs to actively participate in the management of banking crises, banks may become more complacent, knowing that they have a safety net in place. Therefore, it is crucial to strike a balance between empowering DGSs and maintaining market discipline.
The analysis presented in the paper highlights the need for a standardised EU framework for the management of small and medium-sized banks. By allowing DGSs to use available financial means to finance alternative measures, clarifying their role in the BRRD, and establishing their position in insolvency proceedings, the proposed amendments could create a more resilient and efficient financial system in Europe. However, it is essential to carefully consider potential risks and unintended consequences.
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Read the In-Depth Analysis paper (pdf) "Completing the Banking Union: The case of crisis management of small- and medium-sized banks" published by the European Parliament , May 2023