This article was originally published by Bruegel, the Brussels-based think tank. Read the article on their website here.

The European Commission presented its proposals for European deposit insurance last November. Officials hope to stabilise the banking system and decouple banks’ financing costs from the solvency of their host states. This would achieve the original aim of Banking Union: to break the link between states and their banking systems.

But the proposals are met with fierce resistance as the popular assessment is often that tax payers in the North of Europe would have to pay for “rotten” banks in the South of the European Union. German critics in particular have called the proposal an “attack on German savings” and point to high levels of public debt on the books of banks in Southern Europe but they also worry about high levels of non-performing loans.

But a sensible banking union necessarily requires common deposit insurance. Achieving it requires not only attention to details but especially a clear risk sharing and risk reduction strategy. There are various potential models for a European deposit insurance scheme. The most fundamental differences regard the size of the national and European components.

On the one hand, deposit insurance can be a purely national matter. In fact, some EU countries have not yet implemented the minimum level of legally required national deposit insurances – a step that needs to be fulfilled before any further steps with cross-country schemes can be designed. The credibility of national insurance depends on the size of the fund, the health of the national banking sector and state finances, since deposit insurance schemes generally call on the state as a backstop guarantor. But the financial crisis showed that this final aspect can be problematic when states have insufficient resources. This creates major tensions in the banking system, which in turn place burdens on the European Central Bank that push it to the limit of its mandate.

On the other hand is a deposit insurance scheme entirely at the European level. The quality of deposit insurance would thus be totally independent of the individual countries’ policies. However this would create a problem with incentives, where truly shared liability tempts policymakers to dump costs on others. States with less rigorous rules might feel only weak pressure to improve the regulatory framework of their financial system. This would be the case, for instance, with minimum loan-to-value ratios for mortgages or the treatment of foreign currency loans. Through such rules, states influence banks’ risks. Even more relevant, though, is the large exposure of banks to sovereign debt.

The European Commission has now proposed a middle-way: a European deposit re-insurance scheme with a certain national component and a re-insurance with a European pool if national funds are insufficient. Such a system would indeed reduce the risk of “moral hazard” in the sense that the first loss is with the national systems. But the ties binding the banking sector to national fiscal and economic risks would only be weakened, not fully severed. In particular, any national banking crisis would lead to significant disadvantages for all banks located in that country as they would be faced with a higher premium for their deposit insurance. Therefore, in the long run, this cannot be seen as a satisfactory endpoint for Banking Union.

One of the main problems with the current situation is that a single common banking supervisor is pitted against strong national responsibilities. Because national differences remain, governments would understandably want to get involved in the supervision of banks as well. On the other hand, national governments would have a strong case that liabilities for problems that were not discovered in good time by the common supervisor are not theirs.

A coherent solution would be to create a European deposit insurance and resolution authority. Much like the USA’s Federal Deposit Insurance Corporation (FDIC) this authority would take total responsibility for the insurance of deposits. It could fall back on reinsurance from the European taxpayer when even hard bail-in rules are not sufficient to pass on losses to private creditors. However, such a system requires that banks become fundamentally “European”, and, in particular, that they hold fewer government bonds on their books.

A common upper limit on the proportion of government bonds on banks’ balance sheets is thus a vital prerequisite for European deposit insurance. Since this upper limit would be applied in all countries, banks would be incentivized to diversify their government bond portfolio to bonds from governments other than the one in which they are located. The link between banking sectors and states lies not only in implicit and explicit liability; it lies primarily in the huge quantities of domestic government bonds that banks buy. The diversification would reduce that link.

Germany, which is strongly opposing a true Europeanisation of deposit insurance, also has much to gain if Europe’s banking system can finally achieve stability. It can only be won over, though, if this risk sharing is complemented with risk reduction. For once, the ECB would no longer have to assume indirect liability. The German and European banking systems would also become more efficient, since loans would be approved according to economic rather than political criteria.

Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Guntram B. Wolff is the Director of Bruegel.

Image: European Union flags fly outside the European Commission headquarters in Brussels. REUTERS/Thierry Roge.