We have explained in the recent past just why the rotation from a professional European bond-run to a retail bank-run is critical to the euro-zone banking system - with deposit losses creating even more encumbered asset levels among European banks, which would then exaggerate contagion problems as funding pressures mount. The problem is existing deposit guarantee schemes are implemented at the national level and are not currently funded to handle a systemic crisis - this is why there has been so much chatter of a pan-Europe guarantee scheme. However, not only does a euro-wide guarantee rely on credible commitments from core European governments but it misses the redenomination risk - as unlike the US FDIC, it would need to explicitly guarantee the euro-value of deposits. Barclays shares our doubts on the implementation (short- and long-term) of such a solution, noting that Eurozone deposits are greater than eurozone GDP (as opposed to US deposits at ~68% of US GDP). Between operational difficulties, the size of redenomination losses, moral hazard, and the massive (deposit/GDP) contingent liability dependent on actual exit of a member state, we would urge any exuberance over 'talk' of a guarantee to be stymied once again by the dismal reality of implementation and agreement.
With increasing concerns about deposit flight following a potential Greek exit, investors have turned their attention to deposit guarantee schemes in the eurozone.
Current Eurozone Deposit Guarantees
One concern that has recently surfaced is the risk of deposit flight in peripheral Europe following a potential Greek exit from the eurozone
- Redenominated Greek deposits would undergo significant depreciation, imposing massive losses on household savings
- Depositors in other countries at risk of leaving the eurozone would likely respond by moving deposits to accounts in core Europe
The resulting funding pressure on peripheral European banks facing deposit outflows could become an additional source of contagion.
This problem is exacerbated by weaknesses in the current system of eurozone deposit guarantees
- Insurance is implemented at a national level
- Deposit insurance funds are not currently funded to handle a systemic crisis
One possible solution to address the current shortcomings of the existing guarantee schemes is to implement a new euro-wide fund that is jointly backed by the eurozone nations
- The current deposit guarantee system consists of national schemes funded independently by national banking systems, and may or may not include government guarantees
- However, in a crisis, the banking system and government may not be able to make depositors whole
- A new deposit guarantee scheme jointly backed by the eurozone nations would solve this problem
- The strength of the guarantee and the strength of the guarantors are key. The new system would need a credible commitment from core European governments
But, What About Redenomination Risk?
- To prevent deposit flight from fear of redenomination, the deposit insurance scheme would need to explicitly guarantee the euro-value of deposits
- This type of scheme could solve both the guarantor credit-quality problem and the redenomination risk problem of the current system
But while such a fund could, in theory, help prevent deposit flight, there are several key practical issues with implementing the fund
Problems with a Euro-value Guarantee
While a euro-value guarantee scheme could prevent deposit flight following a potential Greek exit from the eurozone, we see several problems with implementing this solution
1. Operational difficulties
- What currency are claimants paid in?
- If they are paid in the new currency, how is the loss rate established?
- How would capital controls impact settlement?
2. Size of the potential redenomination loss
- The redenomination loss would be greater than typical losses in FDIC insured bank failures
- Potential losses are large enough to call the credibility of the guarantee into question
3. Moral hazard problems
- This type of guarantee scheme would make it less painful for peripheral European nations to leave the eurozone
- Under a euro-value guarantee, a country could exit, massively reducing sovereign liabilities, while maintaining a substantial amount of household savings value
4. Finally, a euro-value guarantee scheme would be a massive contingent liability for guarantors that only pays out after a member exit --not an ideal setup
But apart from all that - it's a great idea... come on!!