A stable banking union benefits all

To reduce the likelihood and magnitude of future crises, it makes sense to add a deposit insurance scheme to the two existing pillars of the banking union – the Single Supervisory Mechanism and the Single Resolution Mechanism. This scheme should have a European component, but does not necessarily have to be fully supranational. However, introducing joint liability while sovereigns and banks can pass on their risks to the union level would be disastrous.

These days, there is much debate about whether a common deposit insurance scheme is needed to complete the European banking union, with extensive discussions centring on who will pay more and who less, who has done their homework and who hasn't. Yet the more heated the debate, the more apparent it becomes that some of the arguments put forward are intended to serve vested interests and thus lose sight of the overarching objective: the stability of the euro area and its resilience to future financial crises.

What is the status quo? We are much better prepared for crises than we were five years ago, but still not well enough. More measures need to be taken to reduce the likelihood and magnitude of a future banking – and hence euro – crisis.

But is a European deposit insurance scheme the right weapon of choice? Launched in 2014, the European banking union has already achieved a great deal. A Single Supervisory Mechanism under the aegis of the European Central Bank (ECB) and a Single Resolution Mechanism have been created. Banks are now subject to stricter and more consistent supervision, and ailing institutions can no longer count on being bailed out by taxpayers, instead having to face resolution. And the harmonisation of national deposit guarantee schemes in all EU states means that deposits of up to €100,000 already receive an equal level of protection today. Isn't this enough to shield the euro area from banking crises and their repercussions?

The counterargument is certainly plausible. We cannot yet rule out the possibility of banking crises leading to a bank run and/or a sovereign insolvency, nor of a sovereign insolvency resulting in a banking crisis and a run on banks.

The reason for this is the close linkage between sovereigns and their banks, commonly known as the sovereign-bank nexus. This situation has arisen chiefly because banks are by far the largest creditors of sovereigns. Doubts about sovereign solvency can therefore quickly undermine the soundness of those financial institutions.

The reverse situation, in which a struggling banking system fuels uncertainty about sovereign solvency, is similarly dicey. In extreme cases, these kinds of crisis can raise concerns about the stability of monetary union as a whole – as shown by events in Greece and Cyprus.

To effectively limit these risks, we still need to comprehensively reform the institutional architecture of monetary union. A European deposit insurance scheme could kick in precisely when the purely national systems were under too much strain. This solution is also in Germany's interest: the sovereign debt crisis, in particular, showed how closely the member states of a monetary union are connected and how quickly crises can cross from one euro area country to the next, and indeed how quickly doubts about a member state's stability spread to the entire monetary union. A European deposit insurance scheme can thus strengthen financial stability in the euro area as a whole for the benefit of all member states.

What is the best approach?

While the need for a European solution appears clear, it is not clear which approach would be best suited to curbing risks as effectively and efficiently as possible. And here, the special nature of the EU has to be factored in: it is a union formed of sovereign states, not a federation.

Since 2015 at the very latest, when the European Commission proposed replacing all national deposit insurance schemes with a European one, the idea of a fully integrated EU insurance scheme has had a prominent role in the debate. Its merit is likely to lie in the fact that its clear and centralised structure can alleviate doubts about its ability to function during a crisis.

Nonetheless, a purely supranational pot of funds is not necessarily the most efficient way to mitigate risk in the EU. When it comes to crises that a national system can overcome on its own, there is no need for a supranational pot. In this context, the alternative of an EU reinsurance scheme is currently being discussed, in various shapes and forms, by the European Parliament and by economists, for example. The idea is for a European system of national deposit insurance schemes as a first line of defence. When the national funds are exhausted, the EU reinsurance system would kick in.

This approach also has its strengths and weaknesses. A key advantage is that perverse incentives for national economic policy, which could result in high levels of risk in domestic bank balance sheets, would be better restricted, allowing established national insurance schemes to continue performing their stabilising function. One disadvantage would be the greater institutional complexity which, in a crisis, could make market participants uncertain about whether the system can function.

Irrespective of the decision for a supranational approach or a reinsurance system, deposit insurance can only be reformed if key conditions for a sound foundation are created.

There is a whole bundle of important measures here. For example, the banking union needs clear rules on risk-appropriate handling of new non-performing loans (NPLs) – the initiatives of the ECB and the European Banking Authority (EBA) in this area are vital. The national insolvency regimes should also be harmonised, as these play an important role in the disposal of NPLs. Furthermore, the gaps in the resolution regime that were revealed over the course of 2017 have to be closed. This also includes rapidly building up loss-absorbing capital (MREL).

Very material risk

Moreover, the stock of legacy NPLs needs to be reduced; this is still a major burden not just for the affected European institutions and their national banking systems but also for the euro area as a whole. And finally, there remains a very material risk to financial stability in the euro area: the fact that credit institutions are still able to grant loans to governments (not just) of the euro area, without having to limit or hold capital against them.

This means that a large portfolio in banks' balance sheets remains inadequately secured. Even though there is hardly a more controversial international regulatory issue than this one, we cannot shy away from facing this challenge. Ending the zero risk weighting of sovereign bonds and limiting the concentration of sovereign debt in the banks' books is the right way to better distribute risk and to break up the dangerous link between sovereigns and banks in the euro area.

More than 2,000 years ago, Aristotle's Metaphysics defined something that is still crucial and relevant for the metaphysics of the euro area: the whole is more than the sum of its parts. More than the individual states alone could do, a cohesive euro area creates a vital foundation for the economic upturn in Europe and particularly for export-oriented Germany. Instability or even another euro crisis could have dire consequences for the European – and especially for the German – economy.

Close certain gaps

The first two pillars of the banking union have already greatly reduced the risks for euro area banks and sovereigns. But a number of gaps still have to be plugged, not to mention establishing the final major pillar. However, before we can tackle the issue of a deposit insurance scheme, we have to continue dismantling risks in bank balance sheets, further reduce the banks' susceptibility to crises, and break up the tight sovereign-bank nexus – taking this as our motto: first a solid foundation, then a sturdy house.