22 March 2024

RegCORE Client Alert | Banking Union

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On 4 March 2024, the European Parliament's Committee on Economic and Monetary Affairs (ECON) reintroduced the "Esther de Lange Report" from 2016.
European Union Finance and Banking
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On 4 March 2024, the European Parliament's Committee on Economic and Monetary Affairs (ECON) reintroduced the "Esther de Lange Report" from 2016.1441484a.jpg Dutch MEP Esther de Lange was the then rapporteur in the European Parliament (the Parliament) for the European Commission's (the Commission) proposal to establish a euro area-wide integrated deposit insurance scheme, the European Deposit Insurance Scheme (EDIS) (the Proposal).1441484a.jpg

Following up on the Five Presidents' Report1441484a.jpg on 'completing Europe's Economic and Monetary Union', the Commission first tabled its EDIS Proposal in November 2015 with a view to creating the so-called third pillar of the Banking Union. The debate on EDIS is closely linked to the existing and reformed Deposit Guarantee Scheme Directive (DGSD)1441484a.jpg and the Bank Recovery and Resolution Directive (BRRD)1441484a.jpg, further prudential rules and secondary legislation adopted thereunder, together comprises the crisis management and deposit insurance (CMDI) framework as a comprehensive chapter under the European Union's (EU) Single Rulebook.

In the form of an EU Regulation, the EDIS Proposal generally sought to amend the Banking Union's existing Single Resolution Mechanism (SRM) and the operation of DGSD compliant deposit guarantee schemes (DGS) by establishing a supranational EDIS to distribute the risk associated with protecting depositors from local bank failures to the Banking Union as a whole, and, thereby, to ultimately disentangle what many commentators referred to as the bank-sovereign "doom loop".

The EDIS Proposal initially sought to introduce a gradual (three-step) mutualisation of the existing funds in national DGS. If adopted at the time, the EDIS would have, after a transitional period of eight years, ultimately begun fully insuring national DGS the euro area as of 2024. Fast forward to March 2024, with the Banking Union celebrating its tenth anniversary, the third pillar i.e., EDIS is still missing.

With political momentum on completing the Banking Union having somewhat stagnated in recent years, the most recent market turmoil from March 2023, as well as digital driven deposit withdrawals, have reminded EU policymakers, co-legislators and authorities alike how critical the establishment of EDIS is. National policymakers including those opposed to EDIS in 2015 may also be coming around. As alluded to in depth in a more comprehensive journal contribution on EDIS (available here), "if Banking Union is the seat of financial stability upon which the Eurozone rests, then having a seat made up of at least three legs is likely to be better than just two." Issued in the Journal of International Banking Law & Regulation the aforementioned article sheds light on how EDIS aims to stop European credit institutions being "European in life but national in death".

Having submitted a draft Parliament legislative resolution on the EDIS Proposal on 4 March 2024, the ECON Committee is now, under rapporteur Othmar Karas (EPP, Austria) once again, aiming to reiterate the Parliament's support for EDIS by adopting the ECON Committee compromise text reached in the previous parliamentary term in the form of a draft Plenary Resolution. Well aware of the previously unsuccessful discussions on completing the Banking Union, the Parliament's proposal on EDIS consists, as described in further detail below, of a conceivably watered-down rollout of EDIS as proposed in 2015.

This Client Alert provides an overview of the issues and challenges related to the establishment of deposit insurance at EU level since the Commission first tabled the original Proposal in 2015 and the changes underlying the bespoke Proposal now being reintroduced for fresh consideration. While legislative reforms and proposals have been moving forward with respect to the EU's CMDI framework, as covered in an earlier Client Alert, the nature and form of introducing EDIS (also as part of the broader CMDI) will be crucial in gathering the necessary political consensus throughout the legislative process ahead.

Key takeaways

The question now brought back on the Parliament's agenda, essentially focuses on whether harmonising national DGSs would and can suffice or if a mutualisation at European level, by introducing a common EDIS, would be necessary. This question has been left unanswered (at least in full) in the corridors of the co-legislators since the establishment of the Banking Union. This is the case despite many calls by the first two pillars of the Banking Union, the European Central Bank (ECB), acting at the head of the Single Supervisory Mechanism (SSM) and the Single Resolution Board (SRB), acting at the head of the Single Resolution Mechanism (SRM) repeatedly arguing for EDIS to be built to bolster financial stability and improvements to how the DGSD and national DGS function.

Political sensitivity around this third and final pillar of the Banking Union originates from the concept at the heart of European integration – the very idea of risk sharing – and the potential moral hazard attached therewith, in exchange for greater collective stability. This is compounded by differences in opinion across Member States with regards to sequencing. That is, how precisely to erect the third pillar into its ultimate function of securing the Banking Union? Some Member States believe that having a mutual system is enough to establish credibility, while others want to prioritise the implementation of risk-reduction measures beforehand.1441484a.jpg

In a fully mutualised system, banks would have their risk profiles assessed and their required contributions to a DGS determined relative to the aggregate of banks in the Banking Union, rather than just their domestic competitors.1441484a.jpg Where certain Member States could potentially rely on funds from other national DGSs to compensate their depositors without having contributed their fair share, there is indeed a conceivable risk of moral hazard.
This is especially true where Member States retain the authority to utilise national legislation to shape the size and potential risks associated with their domestic banking sector.1441484a.jpg On the flip side, deposit insurance built on the Diamond-Dybvig model – that is, depositors will not run on their banks as long as they believe they will be protected – suggests that a credible deposit insurance scheme will never actually need to pay out.

The initial Proposal, from November 2015, for the establishment of an euro-area wide integrated EDIS which would constitute the third (and to this day, still missing) pillar of the Banking Union, was based on building up EDIS in three stages, that would be phased in over eight years. Overall, EDIS would ultimately be composed of the individual national DGSs and a European deposit insurance fund (DIF) operated by the SRB.

Table 1: Initial Commission Proposal (November 2015)1441484a.jpg

Stage 1 re-insurance > 2020
The newly created EDIS would provide a specified amount of liquidity assistance and absorb a specified amount of the final loss of the national scheme in the event of pay-out or resolution procedure.

Stage 2 co-insurance 2024
During the second stage, a national deposit guarantee scheme would not have to be exhausted before the EDIS could be accessed. EDIS would moreover absorb a progressively larger share of any losses over the 4year period in the event of a pay-out or resolution procedure.

Stage 3 full insurance 2024
In the last stage, operational as of 2024, EDIS would completely replace the national deposit guarantee schemes and would be the sole – integrated – deposit insurance scheme for deposits in the euro area banks.

As the then Rapporteur for the Commission's Proposal in the Parliament, Dutch MEP Esther de Lange presented her draft Report (the Report) in November 2016. A month earlier, in October 2016, the Commission published its impact analysis, favouring a simultaneous implementation of EDIS (risk sharing) and measures to enhance the stability of the banking sector (risk reduction), as an arguable compromise between the two camps in order to secure a broad majority within the then sitting Parliament. In the Report, however, de Lange adopted a more cautious and conditional approach to introducing EDIS by changing the substance (to only two implementation stages) and timeline of the Commission's proposal.

Specifically, according to Amendment 62 of the Report, the DIF should be funded at national and European level with national DGSs having to become depleted prior to making use of EU level funding. The national DGSs would subsequently remain in existence and, as from 2017, would have provided half of the total funds in the EDIS with their financial means rising continuously and by 2024 have reached the target funding level of 0.4% of covered deposits. In parallel, the euro area-wide DIF would be set up, composed of a combination of individual risk-based sub-funds and a collective risk-based sub-fund providing the other half of total funds available under EDIS. As a result, the Commission's intention to eliminate the significance of banks' nationality would be somewhat reduced.

In terms of substance and timeline, the Report advocated for introducing the re-insurance period (see Table 1 above) only in 2019, with a second and final stage of EDIS to be introduced only after the fulfilment of four conditions, as set out per Amendment 31, by adding a new Article 41g, namely;

  1. 'the date of application, or, where relevant, the expiry of the transposition period of the international standard for Total Loss Absorbing Capacity (TLAC), for Global Systematically Important Banks (G-SIBs), and of revised rules in relation to a minimum requirement for own funds and eligible liabilities (MREL), for all credit institutions affiliated to the participating DGSs;
  2. the date of application, or, where relevant, the expiry of the transposition period of an insolvency ranking for credit institutions, harmonised at Union level, in relation to subordinated debt;
  3. the date of application, or, where relevant, the expiry of the transposition period of a framework for business insolvency, harmonised at Union level, in relation to the early restructuring of companies in order to prevent and better handle the pressing issue of non-performing loans;
  4. the date of application, or, where relevant, the expiry of the transposition period of an act amending Regulation (EU) No 565/2013 and Directive 2013/36/EU, resulting in a binding leverage ratio requirement.1441484a.jpg

Accordingly, the re-insurance period under the Report would start later than the Commission Proposal and last one year longer (i.e., 2019-2023). In contrast to the Proposal, however, the re-insurance scheme provides a 'gradually increasing level of liquidity support' to participating national DGS. In other words, where a participating DGS encounters a payout event or is used in resolution, it may claim funding from the DIF for its liquidity shortfall, the coverage for which increases gradually throughout the reinsurance period;

Table 2: Reinsurance period under the Esther de Lange Report – claimable share of liquidity shortfall coverage by participating DGS 1441484a.jpg

Year 1 reinsurance period (2019)
claimable share: 20%

Year 2 reinsurance period (2020)
claimable share: 40%

Year 3 reinsurance periodd (2021)
claimable share: 60%

Year 4 reinsurance period (2022)
claimable share: 80%

Year 5 reinsurance period (2023)
claimable share: 100%

De Lange emphasised the importance of revamping this initial stage, as it would provide an opportunity to advance on the issue of risk-reduction, 'with a credible system of reinsurance / liquidity support already in place'.

The second and final stage – the EDIS period – would commence starting 2024 as the 'earliest date possible'. Only after fulfilling the conditions under Amendment 31 of the Report, 'the [Commission] would be empowered to adopt a delegated act to establish the exact date of application. In this final stage, an increasing level of excess loss of participating DGSs [would] be covered, achieving 100% coverage after five years. Funding that cannot be repaid with proceeds from insolvency proceedings does not have to be repaid.'

The Council of the European Union (the Council), as co-legislator to the Parliament, had conducted its initial discussion on the proposal for EDIS along with the Commission's communication regarding the completion of the Banking Union back in December 2015. Subsequent progress reports were reviewed at the conclusion of each presidency semester, with the most recent one being in June 2019 under Romania holding the rotating presidency of the Council. Further and subsequent commitments to completing the Banking Union were, however at that time less than fruitful.

Most recently, on 4 March 2024, the ECON Committee of the Parliament reintroduced the Report with the aim to reiterate, once again, the Parliament's support for EDIS, by adopting the Committee compromise - reached in the previous parliamentary term – in the form of a draft Plenary Resolution. By adopting this Resolution, Parliament seeks to maintain the political momentum on EDIS which had arguably began to suffer from a certain degree of fatigue due to limited-to-poor progress on discussions surrounding the completion of the Banking Union.

The Parliament's proposal on EDIS now sets out the following aims, to some degree divergent from de Lange's, approach:

  1. phasing in of EDIS in three phases; (the Resolution, however, only addresses the first phase as proposed in the Report);
  2. a common liquidity scheme during the first phase that could provide loans by national DGSs via a DIF to the particular DGS in need of liquidity;
  3. building up the DIF over a few ears from the allocation of DGS resources within five years; and
  4. the Commission would prepare a report, one year upon entry into force of the first phase, addressing whether to move on to further stages in the phasing in of EDIS, notably including the move to a partial (i.e., Stage 2) or a full European-level DGS and/or a public backstop.

Whether Rapporteur Othmar Karas will be able to garner more political consensus on EDIS than his Dutch predecessor remains to be seen. Recent crises and the responses to, in particular the COVID-19 pandemic orchestrated at European-level, have already shown significant progress in regard to (centralised) policy choices that have allowed further integration among euro area Member States.

Specifically, the COVID-19 pandemic opened the door for common supranational borrowing (in the form of the "temporary Support to mitigate Unemployment Risks in an Emergency" (SURE), the "Next Generation EU" (NGEU) programme and the "recovery and resilience facility" (RFF)), allowing the Commission to provide a joint fiscal effort aligned with the ECB's monetary policy response for the first time, in order to stabilise financial markets and the euro area more broadly.1441484a.jpg

Crucially, however, these programmes remain temporary in nature. Completing the Banking Union, not to mention joint European deposit insurance, would not be. Whether, if at all, Member States' sentiment on vesting Brussels with further competences will require another (deep) crisis to achieve the necessary consensus on furthering integration, is a question EU policymakers, co-legislators and authorities should certainly bear in mind, as it will be their constituents to pay the price.

The ECB, for its part and cautious not to politicise the issue, has, in its SSM role, expressed the view that the introduction of EDIS would indeed strengthen the CMDI framework.1441484a.jpg Moreover, the ECB underlines, that differences in national regimes for dealing with bank failures impede complete market integration and the formation of a uniform level of protection for the same category of depositors (or investors) throughout the euro area and Member States more broadly.1441484a.jpg

Similarly, the SRB has multiple times underlined that a EDIS is indispensable to enhance financial stability, to avoid fragmentation throughout the Banking Union as well as to overcome the sovereign-bank doom loop.1441484a.jpg The SRB also recognises the necessity of gradual progress and political compromises to overcome the current dead-lock by referencing the letter of Eurogroup President Donohoe to the Council in December 20201441484a.jpg which states that the above-described "hybrid model, relying on the existing [national DGSs], completed by a central fund to re-insure national systems, emerges as the most promising avenue [moving forward]".

As some policymakers point out, EDIS could well be, at least for some pan-EU active deposit taking institutions, a more cost-efficient manner for insuring eligible depositor protection and drive cross-border deposit taking activity further while reinforcing financial stability in the Banking Union.

The bigger picture and outlook ahead

The US banking turmoil in March 2023 has reminded markets, once again, that even small rumours that a large institution might fail could cause panic which can ultimately result in bank runs. It does not take much, but when someone eventually shouts, "the emperor has no clothes!", confidence can quickly evaporate throughout the entire financial system from firm to DGS. In an ever more digitalised (banking) world, these self-defeating dynamics are even more prone to unleashing destructive forces. Banking crises are not complicated, in theory. They have infested our economies for centuries, and still they occur.1441484a.jpg

The establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933 under President Roosevelt proved quite effective in stopping bank runs in the US. The landmark step of passing the 1933 Banking Act was arguably only made possible after the US lost countless banks throughout the Great Depression. At the time, the FDIC provided insurance coverage for deposits up to USD 2,500. Today, the FDIC continues to provide deposit insurance up to a limit of USD 250,000 – payable on the day a bank is closed.

Introducing a truly "federal" deposit insurance scheme as such is not as straightforward in the EU. Not least because of the institutional architecture underpinning the Banking Union. That is, a complex web of supranational and national authorities, European-level framework legislation (effectively implemented by national legislation) and a generally cautious attitude of granting further competences to Brussels at the expense of the European capitals, makes a realistic and politically feasible Proposal for a EDIS a legally highly acrobatic endeavour that relies on political will or at least compromise.

Moreover, and connected to the shortcomings of the institutional design of the euro area is the sovereign bank nexus. Ultimately, establishing EDIS to effectively distribute the risk associated with protecting depositors from local bank failures to the Banking Union as a whole could allow the bank-sovereign "doom loop", which has been a major cause of the European crisis in the past few years, to be further disentangled. Although the banking nexus has several layers of complexity, it can be further mitigated by more targeted supervisory means of reducing banks' holdings of their own government debt.1441484a.jpg Unfortunately quite the opposite may still be happening in some EU Member States today. While approximately only 4 percent of US sovereign debt is held by US banks, the corresponding share in Germany and Italy (for instance) is 23 and 20 percent respectively.

While Othmar Karas' efforts on reproposing EDIS are, as at March 2024, still "just" a Parliament Legislative Resolution, i.e. the first step in the EU's "ordinary legislative procedure"1441484a.jpg, it will remain very important for affected financial services firms and policymakers more generally how this version of the EDIS Proposal evolves. Almost 10 years after EDIS was first proposed, it is no coincidence that, following the March 2023 turmoil, that in 2024, during a time when the Banking Union celebrates its 10th anniversary that there are efforts for EDIS 2.0. The very renaissance of this regulatory reform also raises a number of pertinent questions as to whether other relevant guarantee scheme protections in the EU, in particular for the capital markets and insurance sectors, where the EU remains behind coverage breadth and protection levels when compared to the US and other global financial jurisdictions, will warrant change. This is particularly the case, albeit perhaps for a new incoming Commission after the elections for a new Parliament in 2024, addresses the even bigger EU priority of how to increase retail client participation in financial markets? As shown in those other non-EU jurisdictions, greater confidence is largely garnered by higher protection levels and breadth of what is covered.

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