EU Sees Shocks Without Bank Depositor Preference Rule

ECB Executive Board member Joerg Asmussen
European Central Bank Executive Board member Joerg Asmussen has said "we urgently need a European framework for the resolution of financial institutions." Photographer: Andrew Harrer/Bloomberg

European Union deposit-insurance funds would be vulnerable to “huge shocks” unless depositors get preferred treatment over other unsecured creditors, a study on proposed rules for handling failing banks showed.

The EU is weighing whether depositors should be paid back ahead of other unsecured creditors in new rules on bank resolution. If clear preference isn’t given to any depositors, national funds would stand in line with uninsured depositors, senior bondholders and other unsecured creditors to divide up a failed bank’s assets and share in absorbing losses, according to the confidential EU impact study.

Deposit guarantee schemes and the governments that back them “will still be prone to huge shocks to their finances if they do not introduce depositor preference,” the European Commission wrote in the May 7 study, which was obtained by Bloomberg News. The commission prepared the report for a meeting of EU finance ministers in Brussels next week.

All EU nations are required to insure bank accounts with 100,000 euros (about $132,000) or less, a guarantee that was called into question by euro-area deliberations on a bailout for Cyprus. The 10 billion-euro Cypriot agreement ultimately spared insured depositors, while imposing losses on uninsured depositors, underscoring the need for new EU rules on who suffers when a bank can’t meet all its obligations.

Banking Union

“We urgently need a European framework for the resolution of financial institutions,” European Central Bank Executive Board member Joerg Asmussen said yesterday in the European Parliament. The ECB next year takes up supervision of all euro-area banks in the EU’s first move toward a banking union.

The EU study identifies two main options for putting depositors ahead of other creditors to claim assets from failing banks. Under one option, only insured depositors -- whose claim would by represented by the guarantee funds -- would have preference over other creditors to avoid so-called bail-in rules.

The second option would also give uninsured depositors preference over other senior bondholders and unsecured creditors. Under this scenario, which is similar to U.S. policies, uninsured depositors would only face losses after senior bondholders were wiped out, as in the Cypriot example.

Funding Costs

As long as deposit guarantee schemes have seniority over other creditors, which is the case under both options, national funds would not have to absorb any losses under three bank-failure scenarios laid out by the EU study. If they didn’t get preference, the funds might have to make up a shortfall of as much as 45 percent for insured accounts, with uninsured creditors facing similar losses.

If the new law gives preference to insured and uninsured deposits, then bondholders and other unsecured creditors would face losses of about 80 percent. The EU study says this could drive up funding costs while also predicting that the benefits of a clear hierarchy would outweigh any negative impact.

Evidence that granting preferential treatment to deposit-guarantee schemes and unsecured depositors would drive up the cost to banks of issuing unsecured debt is inconclusive, the commission says in the paper. “A simulation even indicates that general depositor preference would actually decrease funding costs for large banks in very severe stress scenarios.”

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