Is it just a matter of time before disaster strikes and a lot of unsuspecting people lose their money?  That is a real possibility and in that crisis there will be no deposit guarantees and no government bailouts. And the EU is now missing the opportunity to plug the hole.

Bear with me as I walk you through it.

Accounts for consumers and small business are generally held at banks. The government guarantees the funds on these accounts up to a certain amount to ensure a modicum of trust in the financial sector. If the bank defaults, the account holder will get at least some of his money back.

The accounts held by banks that are used for interbank settlements, such as those underlying payments between consumer accounts, are held at the central bank. The banks also hold their mandatory capital reserves in these accounts. The accounts are held at the central banks specifically to reduce systemic risk. The reasoning is that because the central bank will not default (except in very exceptional circumstances) commercial banks can hold their liquidity and capital reserves in the account at zero risk. The bank’s liquidity and the underlying payments and deposits are therefore not at risk.

For consumers and business it is also possible to hold a (payment) account with a Payment Institution (PI). This has been possible for a long time as you can in principle ask anyone to hold your money. But because the PIs grew in size and importance in tandem with the growth of e-commerce, the EU introduced the Payment Services Directive (PSD) to regulate these entities.

The PSD requires the deposited funds to be covered 100% by the Payment Institution and to be held in a separate account. So for every euro deposited by account holders, the PI must hold a euro in reserve. Because the deposits are fully covered by these reserves, they are not covered by government guarantee schemes.

This requirement means that the PI cannot leverage the deposits, like a bank does, by lending out a multiple of the amount in deposit under the assumption that not all funds will be collected at once. For every euro held by a bank, the bank can for example lend out 5 euro.

If all depositors do simultaneously demand their money back, which happens in a bank run, people lose their money because the bank simply doesn’t have the necessary funds in house. But if all the deposits held by a PI are demanded back, the PI will be able to pay every last cent back to the creditors because all the money is safely held in reserve. Even if the PI goes bankrupt, the money is safe.

This all seems pretty risk free. But here’s the problem.

The EU has not granted Payment Institutions equal access to central bank accounts and specifically chose not to do so in the draft of the second Payment Services Directive (see here).

Where banks can hold their capital and liquidity with the central bank at zero risk, Payment Institutions cannot.

PIs are thereby forced to hold their accounts with a commercial bank at a risk greater than zero. This risk is greater than zero because the commercial bank may itself default, unlike a central bank.  The PIs deposits are not covered by a guarantee and even if they were the value of the deposits would far exceed the limits of the scheme.

So, this all means that if the commercial bank does fail and the account holders lose their money, the Payment Intuition loses its capital reserves and liquidity it deposited at the bank with little hope of getting it back. In turn, all the merchants and consumers that trusted the PI with their money will lose it too.

Of the EUR 350 billion e-commerce turnover in Europe, a large portion is routed through Payment Institutions or held by PIs in accounts or wallets for longer periods of time. The potential losses could be huge and could seriously damage trust in e-commerce and the financial system.

Of course the Payment Institution should take precautions to prevent losses like selecting a trusted bank and spreading the risk. But spreading liquidity and reserves across multiple financial institutions can be costly and complicates cash management. Perhaps some PIs don’t even realise the risk.

The problem should instead be fundamentally resolved. The EU has allowed this systemic risk to persist and should now take the opportunity to correct this flaw in the upcoming second Payment Services Directive and prevent a potential disaster.