Deposit insurance schemes as a rule of law monitoring mechanism in Europe

Dr Maria Tatsiou

Lecturer in Financial and Corporate Law, UCLan Cyprus

This piece explores the use of deposit insurance schemes as a rule of law (RoL) monitoring mechanism in Europe. This is achieved by looking at financial intermediation as the traditional role of retail banks and the threat of illiquidity that a bank faces due to reputational damage and a bank run. As a response to preventing bank runs and reassuring depositors, the EU has promoted a uniform deposit insurance scheme approach. The piece looks at the steps that must be taken and to what extent the deposit insurance schemes uphold the RoL across the EU by affording equal treatment to all European citizens.

Banks are financial institutions that take part in the payment system by accepting money deposits and extending loans. One of the aims of the business of traditional banking is to assist in enhancing financial transactions by lending to firms in financial deficit or financial shortfall using the funds that other firms have in excess. This process is referred to as financial intermediation.

The traditional role of commercial banks (or retail banks) has been to issue different types of deposits, such as savings, demand deposits, short-term or long-term deposits. The banks receive liquid deposits and then lend to illiquid borrowers to allow credit to flow into the economy. Additionally, they provide “liquidity on demand” to depositors, meaning that depositors can withdraw their money at any point. The function of financial intermediation has enhanced the transformation of “savings from household sector into investments in real assets”. Through financial intermediation, banks can also profit due to the difference between the interest charged for loans and the interest paid for deposits. However, while liquidity creation may be profitable, there is always a risk for liquidity risk materialising if there is a bank run. A bank run occurs when depositors believe that the bank is illiquid or may go into insolvency leading to loss of their savings. If most or all the depositors decide to withdraw their money at the same time, the bank may be unable to fund them. Given that not much cash is saved in the bank, the bank would become illiquid as other assets would have to be sold to fund the deposit returns and meet the demand.

Where a bank’s losses become public knowledge, reputational risk materialises with the possibility of triggering a panic and potentially a bank run arising. Furthermore, if the bank is overleveraged and there is insufficient equity, depositors’ confidence towards the bank is affected and a sudden withdrawal of those deposits may render a bank illiquid. The problem is that no single bank can ever maintain sufficient liquid funds to redeem all or a substantial part of its deposits, making it susceptible to the risk of bank runs. A bank’s illiquidity may turn into insolvency if there are insufficient collateral assets against which a central bank can lend the bank in distress. However, we shall now shift to the focal point of this piece, namely, the protection afforded to depositors through deposit insurance schemes and whether the deposit guarantee scheme participates in upholding the RoL in the EU.

As explained above, liquidity is generated by the bank through financial intermediation. Nonetheless, illiquidity could turn to insolvency, if the bank cannot be bailed out, referring to governmental intervention for injecting money and saving the bank, and depositors may lose their savings. Thus, as a measure of redress, deposit insurance schemes have been developed. These schemes have been implemented across western economies, such as in the U.S.A. and the UK in 1933 and 2001, respectively. Deposit insurance is akin to an insurance policy acting as a protection cover guaranteeing that a depositor is repaid if a bank fails and is unable to repay the deposits after filing for insolvency. Thus, even if the bank collapses, where a  deposit insurance scheme is in place, depositors will be reimbursed with a certain amount of money. Deposit schemes have been adopted in 146 countries.

Since banks now operate across borders, there have been attempts made by the European Commission to harmonise deposit insurance schemes in order to establish a uniform treatment of all European citizens in cases where their deposits are at risk. As we shall see below, the lack of uniform deposit guarantee levels was responsible not only for injustice towards depositors of different Member States (MS), but also for the creation of distortion in the financial sector. Therefore, to avoid discrepancies in depositor protection and to ensure that the EU applies the RoL to ensure that all depositors are afforded with the same level of protection and are treated equally across MS as well as the European Banking Union (EBU), the Deposit Guarantee Scheme (DGS) Directive was passed in 2014. Before we look at those measures, it is important to explain the reasons behind the adoption of deposit insurance schemes and provide a brief historical background of how those have evolved in the EU.

Deposit insurance schemes are regulatory measures adopted for safeguarding liquidity to ensure that consumers would not resort to a bank run that would threaten both market and funding liquidity, as a liquid bank could become illiquid, and ensuring consumers’ confidence in the banking sector. The reason behind this is that depositors may believe that the bank’s assets can no longer cover demand deposits, so they feel inclined to withdraw their money and minimise their losses, as well as display a potential shift in their expectations leading to irrational behaviour. Deposit insurance does not guarantee that a bank run will be prevented, but it remains a measure towards averting depositors from acting irrationally, as withdrawal of deposits may have a contagion effect on other financial institutions and reluctance for interbank lending leading to funding liquidity.

In the EU, Directive 94/19/EC on Deposit Guarantee Schemes was introduced in 1994 to ensure that all EU MS have adopted safety nets for depositors in the case banks fail to pay. While bank failures should be prevented through supervision and the adoption of harmonised measures across the EU through a Single Supervisory Mechanism (SSM), if a bank’s insolvency cannot be avoided, the DGS operate as a tool of stepping in and reimbursing depositors up to a certain ceiling (that is the maximum amount that will be paid back to the depositors), financing their needs. Moreover, depositors whose deposits exceed the maximum amount may have to participate in the bank’s insolvency procedure to recover a part of their claims. The inefficiency of Directive 94/19/EC while dealing with coverage levels in different MS became evident during the times of the Global Financial Crisis (GFC). The “minimum harmonisation” approach of implementation in MS proved problematic as the coverage ranged from €50.000 to €103.291 or even unlimited guarantees in other MS tempting depositors to move their deposits across MS to benefit from higher deposit protection. However, such behaviour can lead both to institutional and systemic distortions, affecting the interest rates earned and creating liquidity strains. Then the government’s intervention and the use of public funds to bail out illiquid or insolvent banks becomes necessary. Such an incident took place in 2008 when depositors started shifting money to banks of other MS. It was thus suggested that there should be a fixed coverage level of €100.000 per bank so that deposit protection could be improved along with consumer’s confidence and financial stability. This was also in line with RoL objectives of achieving uniform standards along of equality before the law as all EU citizens would be treated in the same manner and afforded the same degree of protection when it came to the commercial banking sector. Moreover, the introduction of a pan-EU Deposit Guarantee Scheme was also considered with the aim of replacing existing DGSs as well as support the schemes already existent in MS. The pan-EU DGSs would assist in fulfilling the RoL’s goals in uniformity and equality.

In 2008, following the GFC, the Council set as its priority to restore confidence, soundness, and safety in the financial sector. Among others, the Commission adopted a proposal for further DGS amendments that was published in 2009. One of the first measures was that all MS should adopt a minimum deposit guarantee protection of €50.000 by the end of June 2009 with that being raised to at least €100.000 by the end of 2010 via the implementation of Directive 2009/14/EC. The purpose as well as the limitations of deposit insurance also became evident during the Cypriot Deposit Haircut in 2013 where funds over €100.000 were seized by the Cyprus government. Subsequently, Directive 2014/49/EU, repealed 2009/14/EC, in order to eliminate certain differences between the laws of the MS regarding the rules on DGS. According to Directive 2014/49/EU, MS have to introduce laws setting up at least one DGS that all banks in that MS must join. Moreover, the Directive aims to clarify the situation as to the coverage of depositors at branches of a member of a DGS in other EU MS. Finally, the repayment times of deposit guarantees should be gradually reduced to ensure prompt repayment of depositors.

Additional to the Directive 2014/49/EC, further steps were taken by the Commission to propose the setup of a European deposit insurance scheme (EDIS) in the euro area. EDIS now constitutes the third pillar of the Banking Union in the EU as it builds upon the system of national DGS. The primary aims behind EDIS are to ensure that uniform insurance is offered in the euro area to restore depositor confidence in banks regardless of their location, reduce the exposure of national DGS to large local shocks as well as attain a degree of independence between banks and states. Thus, the current plan for EDIS is as follows. Phase one had to be completed between 2017 to 2020 is called “re-insurance” and establishing that national DGS cannot access EDIS funds unless they have exhausted their own resources. Moreover, EDIS funds would only be provided up to a certain level. Thus, Phase One appears to aim at a reduction of excessive risks taken by banks based on the belief that they will be bailed out and their depositors will be compensated. Furthermore, it seems to encourage putting in place an ex-ante build-up of funds achieving in that way a more harmonised way of how DGS are funded.

Furthermore, Phase Two that has to be concluded by 2024 provides that EDIS will start contributing from first euro of loss at a low level and progressively increase. Thus, compensation will be paid out in conjunction with national DGS. Phase Two heavily relies on the success of Phase One and whether national DGSs have established sufficient measures in building up sufficient buffers to cover depositors’ potential losses. It is yet unclear how successful that will be in practice. However, EDIS will refuse insurance to those who have not fully complied with EU rules, including prudential regulation.

Finally, EDIS will gradually assume 100% of the risk incurred by national DGS from 2024 onwards. Nonetheless, its success remains to be seen as the “Great Lockdown” has really put to test financial regulation and has challenged previous beliefs that the regulatory framework post-GFC can suitably respond to shocks observed in the financial sector. DGSs, thus aim to improve the EU rules on depositors’ protection when bank failures occur by unifying the depositor protection across the EU. This is achieved on a multitude of levels, such as depositors receiving more, simpler, and clearer information from their bank regarding deposit protection, especially before signifying any new deposit contracts. Furthermore, uniform measures are to be fully implemented when it comes to adopting time limits for pay-outs to depositors. Hence, all depositors will be treated equally across the EU since they will be subject to uniform standards and legal certainty as uniformity would attain that the deposit protection insurance as applied by different MS will adhere to transparent, accountable, democratic, and pluralistic processes.

Through DGS and the adoption of EDIS, the RoL mechanism allows for effective dialogue between MS and the EU, by promoting values of non-discrimination, justice, solidarity, and equality. Therefore, the RoL mechanism aims to accomplish regular monitoring and to prevent potential problems arising. The need to respect the RoL has become one of the core mechanisms protection of the financial interests of the EU and the internal market as it reinforces equality before the law as well as establishes trust in (public) institutions. Finally, DGS attempt to guarantee enhanced depositor protection through the application of the RoL monitoring mechanism as well as that the overall financial stability in the single market is ensured.

Lastly, a point that has become of relevance since February 2022 has been the impact that economic sanctions on Russia will have on European Banks. Following the sale or putting in moratorium of several Russian subsidiary banks in different MS, there is a concern that the failings of those banks in the particular MS will activate deposit guarantee payouts towards the clients of that particular bank. Thus, it is expected that the DGSs, along with the sanctions imposed by the European Commission will be called to play an even more significant role in protecting EU citizens as well as promoting freedom, democracy, the rule of law, and human rights.

There was no funding used for the development of this piece.

There is no actual or perceived conflict of interest.