“If the banks fail again, taxpayers will be much better protected”

What would happen to EU banks in a financial crisis?

Reforms in the European financial system have ensured that, if we were to see a replay of the 2008 banking crisis, European banks would survive or could otherwise be saved without government support. That is, without being bailed out by taxpayers.

Such is the conclusion of Wim Boonstra, Special Advisor and Economist at RaboResearch, who reviewed the current EU legislation and literature. He was motivated by the “numerous misconceptions” floating around about the banking industry and the deposit guarantee plan, which guarantees savings deposits. “People are afraid that their tax money might be used to bail out a bank in Spain, or they believe the deposit guarantee plan is government-backed.”

They would be wrong on both counts, says Boonstra. “If you work for a bank you can expect people to corner you at social functions with these types of concerns. It’s important that everyone – especially policymakers and bank employees – is aware of the finer points involved.”

The greatest public fear – and, as it happens, misconception – is that, in the event of another banking crisis similar to the one in 2008, there would be a need for government support to keep major banks afloat. In other words: fear that taxpayers would once again be stuck with the bill, rather than the banks pulling themselves up by their bootstraps.

“I feel it’s important that everyone is aware of the finer points”

- Wim Boonstra, RaboResearch

But a lot has changed since the last crisis. For one, the deposit guarantee plan works and is funded differently than before. New procedures and instruments have also been introduced to prevent major, important banks from collapsing.

Too-big-to-fail banks

Some banks really are “too big to fail” – specifically, major banks that manage payments for large numbers of individuals and businesses. Since it would be ill-advised for these banks to go bankrupt, the Dutch State intervened during the 2008 banking crisis by organizing a bailout.

Boonstra: “A bailout means that an external lender provides new capital or coverage to the troubled bank. This might include anything from capital injections and acquisitions to nationalization and issuing guarantees, all for the purpose of preventing bankruptcy. That external lender in these cases is often the government. Depending on the extent to which the government eventually receives back the financial support it provides – or not – the financial burden on the government and taxpayers can be substantial. The bank’s creditors, and sometimes even financiers, are left mostly off the hook.”

A bail-in system

But the tables have turned, and bailout procedures have been replaced with a bail-in system. In a bail-in operation, it’s the financiers of the struggling bank that bear the losses; these losses are recovered from their own assets. “To put it in layman’s terms: the shareholders are the first to lose their money.” (A cooperative bank like Rabobank would, in this unlikely event, set off the profits retained over the past century.) If the losses exceed the bank’s equity and reserves, they are passed along to holders of subordinated bonds, followed by holders of regular bonds. Next are the savings of major savings customers (defined as holding more than €100,000 in a savings account). “If all this still falls short of the mark, the bank will start looking beyond its own resources – like the option of state support. However, there is zero likelihood of this scenario materializing at this point.”

Another important factor is the increased commitment of the European Central Bank if a large bank is vulnerable to potential shocks. If a bank’s critical functions cannot be transferred to another bank, the bank is placed in resolution instead. This process involves replacing the bank’s management with a team appointed by the Single Resolution Board (SRB), a European authority established in 2015 and tasked with ensuring the orderly resolution of failing banks. Their team will attempt to find a private solution, such as an acquisition by another financially viable bank once the “bad” bank has been restructured. In some cases, essential operations may be transferred to other institutions, after which the bank is liquidated (that is, goes bankrupt). In all these cases, losses are recapitalized through a bail-in procedure.

“There is no chance of this scenario materializing at this point

- Wim Boonstra, RaboResearch

For his study, Boonstra drew on calculations made by the Financial Stability Board, an international financial regulator, which calculated the extent of the losses suffered by the major banks affected by the 2007/2008 crisis, along with their bail-in reserves. He concluded that, if another historically significant crisis were to occur, no government bailout would be needed.

Boonstra: “The loss-absorbing capacity of banks has more than doubled thanks to shored-up reserves and the new bail-in option. In addition, banks are subjected to much stricter regulation than was the case in 2007.”

Smaller banks and the deposit guarantee plan

Smaller banks apply different sets of procedures, which have also been modified since the crisis. This applies notably to the deposit guarantee plan (DGP): the guarantee that savings account holders can hang on to their savings up to €100,000, even if their bank runs into trouble. This is another area of misconception, Boonstra says. “The public debate has shown that many people think this is a government-backed guarantee, which is not the case.”

“The DGP is covered by the banking industry itself,” he explains. “A special fund, the Deposit Guarantee Fund (DGF), has been created for this purpose. The Fund guarantees deposits with its own resources, accumulated through regular quarterly premiums made by all banks except the European Central Bank. This means that, if the DGP is activated because a bank is unable to meet its financial obligations, the bank itself has also paid into the fund used to cover the costs. A differentiation of premiums applies in this case, with banks paying premiums based on their individual risk exposure. This means banks have an incentive to keep their risk exposure in check.”

“If the banks fail again, taxpayers will be much better protected”

- Wim Boonstra, RaboResearch

The DGP is activated when a small bank becomes insolvent. First, funds are collected to provide a loan to cover the savings deposits. If the reserves held in the DGF turn out to be too low, there are several other sources of finance that must be exhausted before a sixth and final option is considered: raising alternative funding, such as government loans.

Boonstra explains that in this scenario, too, government support is highly unrealistic: “Recent bank insolvencies have demonstrated that the DGP payments can eventually be repaid completely using the defaulting bank’s own assets.”

Improved protections for taxpayers

A new European deposit guarantee plan called the European Deposit Insurance System (EDIS) is currently being established. But even without the EDIS, Boonstra concludes that “the DGP, combined with other regulatory laws, already ensures that taxpayers will be significantly better protected during a future banking crisis than during the 2008 crisis.”