A Policy Letter by the Leibniz Institute for Financial Research SAFE shows that an extended deposit insurance scheme covering all demand deposits above 100,000 euros of both private and corporate customers is necessary to prevent bank runs such as the Silicon Valley Bank in the United States experienced and which, subsequently spread to the global banking system. In the current SAFE Policy Letter, economists and legal scholars argue that an expanded deposit insurance system does not have to go without market discipline and private liability.
“Uninsured and short-term bank deposits are one of the main reasons why we observe bank runs. Excluding these deposits from the deposit insurance scheme is a fundamental mistake, not only in the European regulatory framework,” explains SAFE Director Florian Heider. Loss-absorbing capital, i.e. banks’ equity capital and subordinated bank bonds, are fully exposed to the risk of loss; their owners must anticipate the loss of these assets in the event of a crisis.
In normal economic times, however, equity and bail-in bonds are supposed to yield high returns and thus compensate investors for bearing the risk of loss. When and how equity and bail-in bonds can be used to cover losses has to make clear and transparent to all investors.
Deposit Insurance at a cost
In the Policy Letter, the researchers highlight that short-term callable (demand) deposits should be fully insured against losses in value. “As in other areas of life, such insurance comes with a premium that, on average and over time, covers any indemnity that may have to be paid by deposit insurance funds,” says Loriana Pelizzon, head of SAFE’s Research Department Financial Markets. However, it should be noted that in a functioning insurance system, compensation is rarely paid out, as the run as a reason for the inability to pay is eliminated. “Therefore, no tax money is needed for an ad hoc bailout,” emphasizes Tobias Tröger, Director of the SAFE Research Cluster Law and Finance, “also because the sufficiently thick layer of loss-absorbing liabilities shields the deposits from participating in losses and ensures sufficient market discipline.”
The deposit insurance for demand deposits, however, does not come for free: “As with all insurance systems for large risks, some kind of public guarantee is necessary to make the insurance promise credible,” says Heider. To ensure that the deposit insurance system in Europe as a whole is robust, reinsurance that goes beyond the national scope is needed.
For banks that rely heavily on demand deposits, this change could be accompanied by a requirement to increase capital and bail-in bonds. “The deposit insurance of all short-term callable, and therefore run-prone deposits will require a high level of loss-absorbing capital in order for our European banking system to remain stable and viable,” the researchers add.