Since Cyprus’s bailout debacle in March, a question has lurked globally: Will the Cypriot model, in which uninsured depositors took a giant haircut, be the template for future bank failures in the EU?
That question was the subject of intense debate at Tuesday’s meeting of EU finance ministers, and while the group made incremental progress on a common mechanism for winding down failed banks (aka “resolution”), they still haven’t settled on who will have to take losses. Policymakers have been trying to settle this since January 2011, when the European Commission (EC) proposed establishing an EU-wide resolution scheme to keep taxpayers off the hook for future bank failures. Negotiations got a push in June 2012, when EU leaders made direct ESM bank recapitalizations contingent on a common resolution system, and Cyprus’s botched bailout added extra urgency. Now officials aim to submit a formal proposal to the EC and European Parliament (EP) in June, but they have their work cut out for them.
Everyone seems to agree banks and their investors/creditors, not taxpayers, should bear the brunt of future failures—all want to minimize moral hazard. And they largely agree the banks will take the first hit, using capital reserves to cover losses and insured deposits, with shareholders and then junior bondholders falling next. But they differ over the rest of the pecking order. Germany, Denmark, the UK and the Netherlands think uninsured depositors and senior bondholders should be equally liable for the bank’s losses. The EC and ECB think senior bondholders should take losses first, with uninsured depositors “bailed in” only as a last resort (similar to the US’s system), and Germany seems willing to compromise on this. But France thinks the supranational rules should broadly protect uninsured deposits while leaving the door open for haircuts only on a case-by-case basis.
At first glance, the sides don’t seem terribly far apart. But whether uninsured deposits receive preferential treatment is a big sticking point. The arguments for preference are pretty obvious—deposits are private property, and a business or individual parking any sum, however large, at a bank doesn’t intend to take much if any risk with that money. And depositors don’t receive a rate of return commensurate with the risk of huge losses. Shareholders and bondholders, by contrast, inherently accept a higher degree of risk. Those arguing against depositor preference, by contrast, fear it will force bondholders to take higher losses if a bank goes under, which could drive banks’ funding costs higher—bondholders will demand a higher yield. UK Chancellor George Osborne also says it would “create perverse incentives” for companies and institutional investors to dump commercial paper in favor of deposits if they anticipated a failure—a potentially valid point. Then again, if investors had such clear visibility into a looming bank failure, we’d likely see a full run on the bank’s deposits, too.
Arguments on both sides likely have some merit, but in our view, the protracted debate isn’t entirely necessary—deposit risk would likely be a self-correcting issue. No one wants another Cyprus—least of all depositors. But even if uninsured deposits aren’t granted preference, savers will likely find ways to limit their downside risk in the future. Maybe they spread their money around, opening several accounts under €100,000. That would likely improve competition within the EU banking system, with smaller and medium-sized banks getting a nice boost. Or perhaps depositors do more research and favor firms with a big investor base—banks with plenty of stock and bondholders to whack before they get to depositors. Larger depositors might also move funds into money market accounts at brokerage houses, which would keep the demand for commercial paper (a large component of many money market funds) alive and well. And other entities—perhaps companies managing large cash reserves—might park their money in the most stable, liquid sovereign debt, like US Treasurys, UK gilts or German bunds. That pushes government borrowing costs lower.
We’d argue letting the market, not regulators, determine how individuals and businesses allocate their reserves is the best approach—it likely limits the risk of unintended consequences, which can stem from even the best-intended legislation. Those risks were apparent in the other item to emerge from Tuesday’s summit. Defying British and Swedish objections, finance ministers agreed to require each EU state to create a national resolution fund by 2015, funded by a 1% levy on bank deposits. Between Basel III capital requirements, the UK’s pending financial services legislation, the forthcoming Tobin Tax and the UK’s existing bank deposit tax, EU regulators are already whacking the banks—one big reason lending remains weak throughout the region.
An extra deposit tax likely compounds this. It also takes money out of the economy—money that’s sitting in a bailout piggy bank can’t circulate and aid growth. This potential drag seems a hefty price for a vehicle that may not accomplish much if a large bank goes under. For example, the UK’s £12 billion fund would be peanuts compared to the over £300 billion in deposits at one of its largest banks. Even with resolution funds and a bail-in mechanism, governments may still feel compelled to step in if they think it’s the only way to prevent outright panic.
Looking ahead, negotiations over these issues likely continue as proposals are drafted and parliamentary debate begins, and there’s ample chance for regulations to get delayed or watered down. Prolonged discussion likely does fuel uncertainty in European financial firms—one long-running source of fundamental weakness in the sector—and likely weighs on bank lending. But stocks overall likely do fine. Investors have long since realized European economic weakness, regulatory uncertainty and political morass don’t outweigh the myriad positive fundamentals at work globally.