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This paper extends the existing literature on deposit insurance by proposing a new approach for the estimation of the loss distribution of a Deposit Insurance Scheme (DIS) that is based on the Basel 2 regulatory framework. In particular, we generate the distribution of banks' losses following the Basel 2 theoretical approach and focus on the part of this distribution that is not covered by capital (tail risk). We also refine our approach by considering two major sources of systemic risks: the correlation between banks' assets and interbank lending contagion. The application of our model to 2007 data for a sample of Italian banks shows that the target size of the Italian deposit insurance system covers up to 98.96% of its potential losses. Furthermore, it emerges that the introduction of bank contagion via the interbank lending market could lead to the collapse of the entire Italian banking system. Our analysis points out that the existing Italian deposit insurance system can be assessed as adequate only in normal times and not in bad market conditions with substantial contagion between banks. Overall, we argue that policy makers should explicitly consider the following when estimating DIS loss distributions: first, the regulatory framework within which banks operate such as (Basel 2) capital requirements; and, second, potential sources of systemic risk such as the correlation between banks' assets and the risk of interbank contagion.

In December 2013 the European Commissioner Barnier, presenting the\ud Single Resolution Mechanism for the resolution and recovery of banking crises, said\ud it will “break the vicious circle between banks and their sovereigns”. But is there\ud any vicious circle? And if so, will resolution tools be able to break it? In literature,\ud the circular nature of the relationship between banking and sovereign debt crises\ud has not yet been properly addressed. Indeed, most papers exclusively focus on one\ud channel of transmission, either quantifying the effects that banking crises have on\ud public finances or analyzing when banking crises may cause sovereign debt crises (or\ud vice-versa). In this paper we propose a computational approach to quantify the effects\ud of this circular relationship and to highlight how sovereign and bank riskiness may\ud increase because of their interconnection. We quantify the effects of bank distress on\ud the banking system itself, passing through the higher public deficit induced by State\ud support, and the subsequent haircut in government bonds.We then test the effectiveness\ud of the bail-in tool proposed in the Single Resolution Mechanism context. The method\ud is tested on four European countries. Results show that, while limited crises tend\ud to be absorbed by the system, serious crises tend to exacerbate at each turn, so that\ud it becomes impossible to stop them without external intervention. Moreover, results show that a bail-in of 8%of total bank balance sheet can be really effective in breaking\ud the vicious circle and preventing contagion between banks and public finances. This\ud finding supports the bail-in as a valid instrument to avoid taxpayers paying the bill of\ud banking crises

Taxation Papers are written by the staff of the European Commission's Directorate-General for Taxation and Customs Union, or by experts working in association with them. Taxation Papers are intended to increase awareness of the work being done by the staff and to seek comments and suggestions for further analyses. These papers often represent preliminary work, circulated to encourage discussion and comment. Citation and use of such a paper should take into account of its provisional character. The views expressed in the Taxation Papers are solely those of the authors and do not necessarily reflect the views of the European Commission.