We are abundantly told that it is the duty of governments to protect bank’s depositors, which is true to some extent, but should not mean as it surprisingly seems today that banks should not see the interest and safety of depositors as their own duty. Thanks to the public guarantee on deposits, provided by European governments with very little control and requirements, many banks are using directly or indirectly these cheap deposits to engage in very risky activities and to leverage their balance sheet. They often give seniority and privileges to their counterparts in those activities. This puts depositors in a de facto junior, or subordinated, position, and puts taxpayers at great risk. Indeed, during a crisis, the losses on those activities can exceed the (quite low) capital buffers of banks, threatening their survival and the repayment of non-privileged creditors, and thus depositors. Governments have then no other option than to bail them out because deposits with a junior status can hardly be carved out from a failing bank. Secured financing like covered bonds, repurchase agreements, etc, allow banks to get additional funding without correcting their structural weaknesses like insufficiency of capital. The continuous growth of secured funding by European banks is problematic. It has made not only the status of depositors, but also asset encumbrance two major, and growing, problems during the last years. Governments have had to provide banks with large amounts of guarantees and funding, sometimes at considerable cost. Nevertheless, the credit flow has been reduced in many countries, and the cost of credit increased. Meanwhile many large banks have kept much of their risky activities and the remuneration practices that go with them, despite growing proposals for reform. Their capital buffers are usually too low, specially since the understanding and control of risk by their top management and boards is quite insufficient, at almost all of them.
The Banking Union that is now envisaged consists of plans for a European-level supervision framework, a common resolution mechanism, and a common, and solidary, deposit-guarantee system. A banking union with a solidarity mechanism between traditional commercial banking risk is a reasonable objective, but one involving Trading desks and Investment Banking is less reasonable, and would be much more difficult to implement.
Two main options, and a simple deposit guarantee system
One way forward is to limit the risk taking of deposit banks to their traditional activities : making loans. If need be, the banking entity that collects deposits could be separated into such a “commercial bank”, taking deposits and making loans, “ring fenced” on the model of the “Vickers” proposal that has been adopted in the UK for implementation from 2018. This would have the additional advantage of avoiding a divergence of banking regulation between theUKand the Continent.
If that cannot be done (mainly because politicians on the Continent accept the argument that the European Universal Banking model is “too successful” and “too specific” to be broken up; they do not seem aware of the role that regulatory leniency, public guarantees and other subsidies have played in its apparent resilience), a second option would be that at least banks collecting deposits should be requested to protect depositors with a full collateral cover, like for covered bonds. This collateral should consist of diversified loans to the economy at large (loans to individuals, corporations, public sector, anywhere), the same kind as those inside the “ring-fence” of the Vickers model, thus excluding loans to financial activities, risky real estate development, etc… .The quality and diversity of this collateral should be defined and monitored by the National Deposit Insurance Company (NDIC) in each country, or a European one (EUDIC). This should not be a deterrent to lending to the economy, quite to the contrary. In fact, the State guarantee now generously given to any bank should rather be reserved for banks that can give acceptable loans to the economy as collateral. These “covered deposits” would be rather easy to define and no more difficult to manage than “covered bonds” which have multiplied lately in Europe. A bank in difficulty could then be reorganised, bailed in by its creditors, or left to fail. Its deposits and loan portfolio could be carved out in an orderly way, and at much less cost to taxpayers. To limit systemic risk, central counterparties in securities and derivative transactions should be generalised, and securities lending kept in check.
Commercial banks that do not give privilege to other creditors, have enough equity, and have a reasonable lending policy, monitored as such by the regulator and the NDIC/EUDIC, could be exempted from the obligation to collateralise their deposits.
A deposit guarantee and resolution mechanism could for example be based on NDIC’s, under the umbrella of a European one- EUDIC- that intervenes only if the NDIC’s have correctly applied the rules (for instance checked adequately the quality and diversity of the assets in the collateral). The cost of insuring deposits should be defined in function of the risk profile of each bank and each portfolio of collateral. It should be paid by banks to the NDIC, which would pay the EUDIC a premium for the reinsurance it provides.
If it looks simple, that should not be held as a weakness.
Eric De Keuleneer
Solvay Brussels School of Economics Université Libre de Bruxelles