Europe's Second Pillar: A European Deposit Insurance System, Complementing Monetary Union, Can Help to Contain the European Race to the Bottom in Financial Sector Subsidies and Regulatory Arbitrage

What do places such as Reykjavik, Edinburgh, Dublin, Brussels, Dusseldorf, Munich, Milan, Vienna, and Stockholm have in common? These regional European financial centers sacrificed basic regulatory and oversight principles over the past decade for the sake of unmitigated growth. They harbored an ambition to quickly join the top-tier European financial capitals of London, Frankfurt, and Paris. Home to banks such as Kaupthing, RBS, HBOS, Depfa, Fortis, KBC, WestLB, IKB and BayernLB, Unicredit, Erste, and Swedbank, these cities are now the hosts of some of the worst casualties of the current financial crisis. One of the key promoters of the new regional centers was Charles McCreevy, Irish finance minister from 1997-2004, whose biggest coup in 2001 was to lure Depfa, the German public-sector covered bond issuer, from Frankfurt to Dublin by offering its management substantial tax savings and relaxed banking supervision. Once in Ireland, Depfa--stretched by razor-thin margins in public finance--operated under the high asset-to-liability mismatches that German regulators had been eyeing for years and finally ended in 1999. The 2008 financial crisis wrought disaster on Depfa, which had been taken over in 2007 by Munich-based Hypo Real Estate. Alarmed by what it was hearing, German regulators in March asked Ireland for permission to review Depfa's books, which prompted them to instruct Hypo Real Estate in Munich to instruct Depfa in Dublin to close positions. Despite that order, when Hypo Real Estate had to be rescued with a 35 billion [euro] German public bailout package in October, Depfa Ireland was still exposed to huge money market roll-over risk and remained the key source of Hypo Real Estate's problems. The supervision chaos was personified by German finance minister Peer Steinbruck, who on October 15 mistakenly claimed that German supervisors had no right to inspect a bank located in Ireland.