Author: Nafisatu Wiafe Ansah, LLB University of Padova, 2015-2016, e-mail: [email protected]
Legal Editor: Bader Kabbani, LLM International Commercial and Economic Law, SOAS, University of London, 2020-2021, e-mail: [email protected]
Abstract
Banking is a complicated business and depositors are associated with the difficult nature of banking. Credit institutions can become non-liquid, insolvent, or fail. The victims of the situation of non-liquidity and failure are the clients, especially the depositors, who are at risk of losing everything. This article seeks to shed light on the risks of depositors and the legal framework in the European Union to protect depositors and their funds.
A brief synopsis of credit institutions
The European legal system defines a credit institution, in Article 4(1)(1) of Regulation (EU) No 575/2013 as “an undertaking the business of which consists of any of the following: to take deposits or other repayable funds from the public and to grant credits for its own account. The total value of the consolidated assets of the undertaking is equal to or exceeds EUR 30 billion”.
In other words, banks are businesses with a considerable amount of funds as capital, and whose main business is to take funds from the public (depositors and investors) and to grant credit (mainly in the form of loans) to the public in their role as intermediaries.
Credit institutions contribute in a very important way to the “real economy” (the part of a country’s economy that deals with the production of goods and services) and to the financial stability of a country by providing functions that may be deemed critical[1]. They “create money” by increasing the monetary base or monetary supply through the loans granted.[2]
Due to the delicate nature of functions performed by banks, they are exposed to a series of risks (such as illiquidity, insolvency, failure, etc.) stemming from the very characteristics of the institutions, such as the discrepancy between maturity period of deposits and loans, the confidence of market participants and interconnectedness.
Thus banks “borrow short and lend long”, meaning that they take short-term deposits and lend them to debtors for a longer period, causing a mismatch between the maturity date respectively of the deposit and of the loan.
The strength and smooth running of banks heavily rely on the confidence that market participants have in the ability of the institutions to pay their debts and obligations as they fall due. The delicate nature of banks and their reliance on the confidence of the participants mean that any time such confidence is lost or negative information regarding the liquidity situation of banks or their solvency, depositors may panic and rush in mass to retrieve their monies in a “bank run”.[3]
Another risk factor for banks lies within their interconnectedness. Currently, banks are so interconnected with each other to the point that the failure of one bank may easily trigger the failure of others, creating a domino effect that could negatively impact the international economies.[4]
Depositors, their risks and European Union Protection scheme
Credit institution depositors may be classified as a class of bank creditors who place their money in banks for safekeeping. Depositors have the right to withdraw their deposits according to the timeframe set forth in the terms and conditions governing the banking agreement. Depositors, especially if they are uninsured in the event of losses, are a group of creditors that are particularly exposed to the negative effects of the risks faced by banks because in case of insolvency, failure and subsequent liquidation, they may “encounter restrictions in accessing their funds or even lose their deposits (liquidity loss) and there is the risk that their deposits may decrease in value (credit loss)”[5].
The vulnerability of this class of creditors has made it necessary to establish a protection scheme to protect depositors. Thus in 1945, the European Parliament began establishing Deposit Guarantee Schemes (DGSs) to refund depositors a limited amount of their money thereby increasing depositors’ confidence in the safety of their deposits and increasing financial stability.
The first European DGSs were created in 1994[6] with a directive that sought to create sufficiently and harmonized minimum protection throughout the union member states. This directive, however, did not reach its intended purpose; it provided a low coverage level that was not sufficient to guarantee effective depositor protection and it proved disruptive to the financial stability and internal market. This is because the protected amount was 20,000 euros, with the option for Member States to determine higher coverage. Therefore, in 2008, after the recurring bank runs and banking crises, the European Institutions made it necessary to establish a better and more cohesive approach to the protection of depositors. Thus, the directive was amended in 2009 and in 2014[7], which increased the minimum coverage throughout the union to 100,000 euros, gradually reducing the repayment times of deposit guarantees with payments being made within three months. The new legislation also seeks to attain a higher level of harmonization in the funding of DGSs, and protection of covered deposits and reaffirms the imperative objective of managing bank failures without recourse to taxpayers’ funds (which is used in liquidation or even resolution) by ascertaining that they are financed entirely by the banks.
In conclusion, it is safe to say that DGSs have come a long way from their initial state and have greatly strengthened the ability to respond to distress in the financial system by assuring adequate coverage to depositors, therefore restoring some confidence in the financial market. However, the level of coverage needs to be reviewed to offer a higher minimum level of coverage and also a reduction of the payout timeframe.
I think that greater effort should be dedicated to creating more uniformity in the protection of depositors in the union (starting from establishing a more cohesive and harmonised banking union) which would culminate in a unified European Depositors Guarantee Scheme (instead of the current strictly national-based DGSs) to provide a unified coverage of depositors, especially in light of the transborder nature of the business done by banks. An EU-based DGS would provide a cohesive system of coverage in terms of the covered amount, the time frame of disbursement and even governing regulations, but it would also significantly impact the way the failure of banks is treated and the role DGSs have when relevant authorities have to decide between subjecting ailing banks to ordinary liquidation or resolution procedures.
Bibliography
- https://www.ecb.europa.eu/stats/financial_corporations/list_of_financial_institutions/html/index.en.html.
- https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy.
- https://www.cambridge.org/core/journals/european-journal-of-risk-regulation/article/abs/relevance-of-trust-and-confidence-in-financial-markets-to-the-information-production-role-of-banks/E08C2A1A730C29E1054C3E1BB0599E02.
- https://www.investopedia.com/terms/c/call-deposit-account.asp.
- https://finance.ec.europa.eu/banking-and-banking-union/banking-regulation/deposit-guarantee-schemes_en.
- Michael McLeay, Amar Radia and Ryland Thomas, Money creation in the modern economy, 2014, pp.1-4.
- Bahriye Basaran and Mahmood Baghieri, The Relevance of “Trust and Confidence” in Financial Markets to the Information Production Role of Banks, published online by Cambridge University Press: 2020.
- A. Peltonen, M. Rancan and P. Sarlin, Interconnectedness of the banking sector as a Vulnerability to crises, 2018, pp. 2-5.
- Kaufman, Depositor Liquidity and Loss-Sharing in Bank Failure Resolution, 2003, pp. 1-3.
[1] The Commission Delegated Regulation 2016/778 Article 6(1)(b) states that a function shall be considered critical when: “The disruption of that function would likely have a material negative impact […], give rise to contagion or undermine the general confidence of market participants.
[2] Michael McLeay, Amar Radia and Ryland Thomas, Money creation in the modern economy, 2014, pp.1-4.
[3] Bahriye Basaran and Mahmood Baghieri, The Relevance of “Trust and Confidence” in Financial Markets to the Information Production Role of Banks, published online by Cambridge University Press: 2020.
[4] T.A. Peltonen, M. Rancan and P. Sarlin, Interconnectedness of the banking sector as a Vulnerability to crises, 2018, pp. 2-5.
[5] G. Kaufman, Depositor Liquidity and Loss-Sharing in Bank Failure Resolution, 2003, pp. 1-3.
[6] Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit guarantee schemes.
[7] Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes.
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