Today’s meeting of eurozone finance ministers in Luxembourg will focus on the completion of the banking union and the introduction of a European Deposit Insurance Scheme (EDIS). The Director of the Leibniz Institute for Financial Research SAFE, Jan Krahnen, sees progress in this, but emphasizes that a European deposit insurance should best be designed in the form of reinsurance to avoid misaligned incentives and minimize risks for the countries involved.
“It is important to discuss the further steps towards the completion of the banking union. In this context, the establishment of a European deposit insurance scheme is what makes the banking union project complete in the first place, as this will ensure the long-term viability of the financial system,” says Krahnen. “However, the design of the deposit insurance should be organized permanently in the form of reinsurance.”
In a SAFE White Paper, Krahnen and other authors have developed a viable proposal for a “European Deposit Reinsurance Scheme” (EDRIS). The model aims to establish a deposit reinsurance scheme at the European level that would counteract existing risks and prevent the threat of risk communitization from the outset. At its core, the EDRIS model envisages linking the deposits of savers by means of national primary insurance and European reinsurance with risk-adequate premiums.
Counteracting false incentives
“In our model, legal liability up to a certain amount is regulated at national level. In the case of higher losses, European reinsurance takes over up to the legal limit of 100,000 euros. The notorious doom loop of bank weakness and sovereign financial crisis can thus be prevented - and, moreover, liquidity support can be provided to national primary insurers if necessary,” Krahnen explains. Funding could come from the European Stability Mechanism (ESM).
Supervision in the EDRIS model is to be governed by the subsidiarity principle: Primary insurers supervise “their” banks, set risk-adequate premiums, and operate and manage national rescue funds. At the same time, primary insurers are supervised by the European reinsurer. In setting premiums for primary insurance and reinsurance, a differentiation is to take effect that takes into account probabilities of default and expected losses by country and credit institution.
“Reinsurance, as we propose, disciplines deposit insurers in a European context. This is an important design proposal that adds value: premium differentiation can be used to counteract misaligned incentives and ultimately provide assistance to countries where, for example, a bank run would bring down other banks as well,” Jan Krahnen elaborates.