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The European Deposit Insurance Scheme: a myth or a fact? – Jessica Friggieri and John Sammut

10 Dec 2019 12:00 | Deleted user
The Accountant – The Future Professional Accountant in Business. Autumn 2019 (MIA Publication)
The global financial crisis of the last two decades not only challenged the regulatory and operative framework of the financial services regulation and supervision, but also highlighted the importance of financial consumer protection. Since the Great Depression of over eighty years ago, the banking system continued to witness a series of weaknesses caused by various factors. In fact, the support given to banks by EU in recent years was equivalent to an estimated third of its economic output.

A Deposit Guarantee Scheme (DGS) has the specific task of protecting less financially sophisticated small depositors from the risk of losses they might incur when a member bank fails. Due to the close bond existing between banks in a financial system, a DGS provides the mechanism which enables depositors to have quick and immediate access to their funds even in the event of a bank’s failure. By participating in this financial system safety net, a DGS helps to keep the financial stability in stressful conditions under control by preventing depositors from engaging in a bank run. In addition to the DGS function to maintain public confidence in the banking system, banks’ risk levels need to be assessed both by a strong prudential supervisory activity through an appropriate regulatory framework and sound accounting and financial reporting regimes.
Credibility is fundamental for a DGS to contribute successfully to the financial system stability. The DGS needs to be adequately designed, correctly implemented and properly understood by the public. A deposit guarantee system has to be able to withstand a systemic crisis by itself or capable of dealing with only a limited number of simultaneous bank failures.
Despite the increased standardisation and coverage in DGSs, there is strong evidence that they may have failed to act as a “line of defence” during periods of crisis, leading to several amendments and proposals in reaction to financial crisis. The way that governments and central banks have responded to the financial crisis in recent decades - through bail-out of failing banks - indicates that DGSs failed in their objective. EU legislation already ensures that all deposits up to €100,000 are protected, through their national deposit guarantee scheme (DGS) in case of a bank failure. However, national DGS can be vulnerable to large local shocks.
For this reason, a European Deposit Insurance Scheme (EDIS) was developed to provide a stronger and more uniform degree of insurance cover for all retail depositors in the Banking Union, ensuring the level of depositor confidence in a bank does not have to depend on the bank’s location.
In 2012, the European Council agreed on a roadmap for completing Economic and Monetary Union (EMU) based on deeper integration and mutual support. Completing the Banking Union is an indispensable step to a full and deep EMU while reinforcing financial stability in the EU. The first pillar of the Banking Union consists of a common framework for supervision of banks to be implemented by the Single Supervisory Mechanism (SSM); the second pillar consists of a common framework for bank resolution to be implemented by the Single Resolution Mechanism (SRM). These two pillars have already been put in place. A third pillar, the EU-deposit insurance scheme, is still required and needs to be put in effect now. In contrast to the situation in 2012, the European banking industry is on a much more solid footing with more stringent capital and liquidity rules and a centralised supervision and resolution in place.
On 24 November 2015, the EU legislative proposal for a European Deposit Insurance Scheme (EDIS) was introduced to further strengthen financial stability and depositors’ trust whilst reducing the dependency of the financial institutions on national governments in times of crisis.  The institutional framework for the EU deposit guarantee schemes consists of three main elements (i) the Directive (DGSD), (ii) the national legislations and rules, and (iii) the network of cooperation and information sharing between schemes and supervisory authorities.
The setting up of the EDIS addressed the problems for large cross-borders exposures through banks’ branches and subsidiaries. This helps to remove competitive distortions, deal with administrative burdens, avoid branch/subsidiaries’ consumers confusion and, most importantly, preserve the internal market for retail banking.  Given that the premise of a Banking Union breaking the vicious circle between the sovereigns and the banks, a common system is an important element.
The European Deposit Insurance Scheme is being rolled out in three stages, deployed gradually through to its full implementation in 2024:
  • Reinsurance stage (from 2017 to 2020): national deposit guarantee funds will only be able to access European funds when they have used up their own funds. Funds requested must be justified and in response to a possible moral risk. Additionally, the deployment of the funds will be closely monitored.
  • Co-insurance stage (2020 to 2024): during this stage, the national funds will not be obliged to exhaust their own resources before accessing European system funds. The European system will be responsible for part of the costs from the moment that money has to be returned to deposit holders. The contribution rate will start at 20% and increase gradually over the following four years.
  • Full insurance (2024 onwards): the participation rate in the European Deposit Insurance System is expected to reach 100% at this date, after which the single resolution fund will have been fully established.
During the first stage, national DGSs were requested to exhaust national funds before making use of European funds (although with a limit). From the second stage of the process, then, risks will be genuinely mutualised as payments are shared from the first cent. European funds are, therefore, used without the requirement for national funds to be used first.
Once EDIS goes into effect, banks will be compared to other EU-wide banks based on a deposits and risks profile. In this case, a local bank might have to pay more under EDIS than it did under its national DGS. This could lead to more discussions and slow down a smooth implementation of EDIS.
While the creation of the EDIS introduces fundamental advantages, such as improved credibility, simplified pay-outs and failure resolution and reduction of moral hazard, it could also lead to disadvantages such as:
  • international supervising authorities as a requirement. The creation of a cross-border deposit insurance scheme is inconceivable before an international supervising institution and regulation are implemented.
  •  political obstacles if specific country problems hinder the establishment of such a project.
  • fund management/investment policy may also exist in connection with the management of a large pan-European deposit insurance fund.
  • administrative and operative complexities (IT systems, controls mechanisms) needed to run the scheme.
A national DGS is obliged to inform the EDIS if there is the possibility of a bank failure.  Should compensation to depositors be necessary, EDIS would have 24 hours to decide the amount of funding to be provided on its part immediately.  In the case of a systemic bank failure where the EDIS fund would not be sufficient to cover all compensations required, pro-rata funding would be provided.
Article 12 of the DGS Directive, which allows borrowing between DGSs, may be considered as a step towards a common EU-wide fund.  The Directive allows for borrowing between funds on a voluntary basis and on condition that this does not exceed 0.5% of covered deposits of the borrowing DGS, and subject to repayment within five years. Article 14 titled “Cooperation within the Union” covers the problem of treatment of depositors at branches set up by credit institutions in another Member State (MS).  The home MS of the bank will have the financial responsibility of the branch, but any compensation payment will take place through the DGS in the host member state, acting as a ‘single point of contact’ on behalf of the DGS in the home member state.
Unlike the supervision of significant banks and resolution required by the Single Supervisory Mechanism (SSM), EU depositor protection remains, to date, decentralised.  The crucial issue for DGSs remains the link with resolutions, particularly in the event of a cross-border banking crisis. Article 11 of the DGS Directive allows member states to use its funds for resolution as a last measure to prevent bank failures when conditions imposed on the credit institution are met.  There is a possibility that different decisions could be taken by the Member States, according to their financial stability concerns, in cases where cross-border banks face financial difficulties.
The EDIS dossier was also discussed during Malta’s EU Presidency in 2017 where Malta’s stance on the EDIS proposal emerged very close to that of the EU Parliament: prioritising the achievement of risk reduction while limiting risk mutualisation.
Extensive debate is still needed to bring the EDIS in line with the EU’s planned reforms on financial supervision.  Work on the draft proposal to align EDIS with all the requirements of the 2016 roadmap is ongoing; progress, however, has been slow following disagreement between member states that are ready to implement EDIS immediately and those that want significant conditions on the introduction of EDIS. The gradual implementation of EDIS should be linked to the progress made on the other parts of the Banking Union and to the progress made in addressing legacy risks.
Currently, the discussions are still ongoing at Working Party level. In time, we will know if the DGSs would need to be revised again to ensure achievement of their role in coping with a systemic banking crisis.  This is especially relevant in view of the 2024 target transition period, by which year it is expected that the DGS and resolutions fund may not have been fully funded. Only time will tell if the EDIS proposals being made now will become a reality or remain a myth.
This disclaimer informs readers that the views, thoughts, and opinions expressed in the text belong solely to the authors, and not necessarily to the author’s employer, organization, committee or other group or individual.

Jessica Friggieri LL.D MA Laws
Jessica Friggieri is a Lawyer graduated from the University of Malta. She is former Lawyer of the Malta Depositor and Investor Compensation Schemes, and now Legal Analyst for the Financial Crime Compliance Unit. Also, Secretary of the Malta Protection and Compensation Fund.

John Sammut MA Fin Serv, MA Risk, BA (Hons) Accty ACIB, CPA
John Sammut is a certified public accountant, graduated from the University of Malta and presently works as Head - Internal Audit at the Malta Financial Services Authority. He carried out a thesis title “A Study of the Role and Sustainability of the Depositor Guarantee Scheme in the EU and Malta.”

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