The savings and cooperative banks in Germany, organized in the institutional protection schemes of the Federal Association of German Cooperative Banks (BVR) and the German Savings Banks and Giro Association (DSGV), should be subject to regulation like major banks. This would do better justice to the actual market and risk situation of closely interlinked institutions within each association than the current regulatory treatment of unconnected individual institutions, argue scholars from economics and law at the Leibniz Institute for Financial Research SAFE in a current in-depth analysis commissioned by the European Parliament.
The analysis shows that, on the one hand, customers can benefit from the advantages of the institutional protection schemes because they are well safeguarded against financial losses in times of crisis. On the other hand, however, the analysis shows that financial bailouts happen all too easily at the state banks (“Landesbanken”), which create a burden on the federal and state budgets. The researchers find that banking networks with institutional protection schemes should be regulated like major banks subject to ECB supervision within the Single Supervisory Mechanism (SSM). This could eliminate the need for government aid and increase the banking market’s overall financial stability.
“Preventing moral hazard”
“We have weighed the advantages and disadvantages of the institutional protection schemes. We find there is an imbalance in favor of the savings and cooperative banks’ networks in the banking system,” says Jan Pieter Krahnen, SAFE director and one of the analysis’ authors. Tobias Tröger, Director of SAFE’s “Law & Finance” Cluster, and also one of the authors, adds: “Institutional protection schemes, as they exist in Germany, enjoy considerable regulatory privileges. Alignment with the regime applicable to major banks and centralized supervision by the ECB could prevent moral hazard.”
As the authors note in their analysis, institutional protection schemes offer three main advantages that strengthen the position of regional banks in the market: They have powerful internal warning systems that enable individual member banks to be restructured early on in challenging situations. By limiting their business activities to a clearly defined region, the savings and cooperative banks concentrate sustainably on private customers and companies in their respective geographical area, thereby strengthening regional growth. Ultimately, the mutually agreed institutional protection scheme provides a protective umbrella that enables banks to guarantee all deposits, regardless of their amount.
The disadvantages of institutional protection schemes weigh heavy
However, the disadvantages of institutional protection schemes weigh heavily, too: The protection commitment depends on the members’ approval in individual cases, resulting in a risk of failure and underinvestment. Moreover, the institutional protection scheme is not unlimited but only covers as much as the capital and liquidity resources of the entire joint liability scheme can bear. Given the similarity of business models within an association, diversification within networks is low. In the event of a restructuring, the loss participation of a bank’s creditors remains excluded in all cases. This largely removes the institutional protection schemes’ members from the reach of national and European resolution authorities.
The researchers believe that treating large banking networks, interlinked by the joint liability within institutional protection schemes, equal to major banks, could achieve direct ECB supervision within the SSM. This would contribute to the standardization of supervisory practices, considering systemic risk. Moreover, the analysis emphasizes that the integration into a European deposit reinsurance system, as currently discussed in Brussels, will improve the financial stability of the entire banking market, counteract existing risks, and prevent the mutualization of risk at the European level.