Look behind Germany’s surprise call for deposit insurance

Andrea Enria, chair of the supervisory board of the ECB, gave a speech in London at the end of October celebrating some of the successes of banking union – establishment of a single supervisory mechanism or large banks, NPLs brought down from €1 trillion to €600 billion in the last five years – while also lamenting its failures, notably the lack of a European deposit insurance scheme.

Without this, a euro deposited in a country with weak banks might easily flee to a stronger bank in a different country at the first signs of stress. The single-currency project itself remains incomplete.

What a surprise then that one week later, Olaf Scholz, finance minister of Germany, the country regularly blamed for blocking such a scheme, should lay out in the FT his ideas for the completion of banking union, along with its so far missing third pillar.

Scholz actually calls not for a European deposit insurance scheme to replace national schemes but rather for a new European deposit reinsurance scheme to enhance those national arrangements.

Olaf Scholz, finance minister of Germany

In the event of a bank failure, the first resort for depositors would be to national insurance schemes; then, only if those funds are exhausted, to a European fund providing limited additional liquidity through repayable loans. Should further financing still be needed, the relevant sovereign would then step in.

If this is meant to signal a new breakthrough, it is so hedged around as to dampen any celebrations. It may be that Scholz is mindful of his domestic audience. German voters are hardly likely to welcome the notion of putting their money on the hook to bail out depositors of troubled banks in what they see as profligate southern European countries.

Doom loop

When Scholz also argues that European banks must take capital charges against the national sovereign bonds that they have all loaded onto their balance sheets, a cynic might begin to think he is offering German support for deposit insurance only by making it conditional on steps other European countries – Italy most obviously, but others as well – cannot accept.

German bunds would be zero risk-weighted, clearly. Others would not. In the European sovereign debt crisis at the start of the decade, national banks supported sovereigns by buying their bonds just as credit concerns and spreads rose.

Yes, that has created a doom loop. But pro-cyclical rising capital charges for holding sovereign bonds of countries in the initial stages of budget stress – when international banks and investors step back – might exacerbate the next crisis.

Breaking this loop is better left to bank regulators in Basel, rather than open political tit-for-tat.

Perhaps one day, financially robust German banks might move back to the global scene, piggy-backing the pan-euro area market as a whole 

 – Sam Theodore, Scope

Is this just an initial negotiating position? Might Germany concede on capital charges against government bonds if Scholz’s other conditions are met: namely tax harmonization, including uniform taxation of banks across the EU, and common insolvency and resolution procedures for all banks, not just for large ones?

This last would leave much less discretion to national regulators to avoid bailing in bondholders of failing smaller lenders, some of whom might be retail depositors and most, of course, also voters.

Intriguingly, while framing his call to complete banking union against the risk of the continent becoming overly dependent on US and Chinese banks and getting “pushed around on the international stage”, Scholz cites the US Federal Deposit Insurance Corp as a model.

Consolidation

The FDIC is many things, including an agent of consolidation. Its first resort when taking over a troubled small US bank is usually to fold it into an a stronger in-market competitor or regional consolidator.

The theme of coming consolidation is what lies behind these latest German proposals. Germany’s own fragmented banking scene needs more mergers and acquisitions and not just among the cooperative and savings banks. Its national champions, Deutsche Bank and Commerzbank, are shrinking into Europe’s second tier, far behind the French, Spanish, Benelux and even Italian regional banking powers.

Sam Theodore, Scope

For consolidation to proceed on a European scale, banking union is essential. Sam Theodore, managing director at Scope, wonders if Scholz might be playing a long game here.

“Perhaps one day, financially robust German banks might move back to the global scene, piggy-backing the pan-euro area market as a whole,” he says. “Not dissimilar to what the French banks aimed for when the euro area was established in the early 2000s.”

If common resolution regimes for all banks enshrine bondholder bail-ins and promote consolidation, so improving the profitability of European banks, then perhaps Germany could support a European deposit reinsurance scheme, rationalizing that it would be much less likely ever to be called upon.

For now, this looks a long way off. Even after a mild recent rally, euro-area banks now trade on a cost of equity close to 11.8%, according to analysts at UBS.

Their return on equity is half that.

For the European banking sector to survive, profitability must improve. That requires scale and consolidation – for which banking union is a must.

Even Germany wants to get on with it now.