Playing with Fire in Cyprus

Early Saturday morning, after 10 hours of negotiations, it was announced that Euro Area (EA) finance ministers had agreed upon a bailout package for the government and banking system of Cyprus. The total financing needs of Cyprus are 17 billion euros ($22 billion), which equates to approximately 100% of Cypriot gross domestic product (GDP), making this by far the largest bailout relative to the size of the economy yet in the EA. Despite the large relative magnitude however, the absolute size of the bailout is actually quite small. Cyprus represents less than one half of one percent of EA GDP, so even though the bailout equals the entire size of the Cypriot economy, it is rounding error in the scale of the EA overall. Why then was it necessary for the finance ministers from all over the EA to work through the night to hammer out a deal? Why not just give them the money in the interest of reinforcing the unity of the EA and move on to the next critical item on the list? Fairness and avoiding bad incentives are clearly important motivations, but precedent is the key factor. Whatever rules are established for one country will be assumed to apply to all, and while Cyprus is relatively small, Spain and Italy, who also have onerous debt burdens, are very large, and therefore a simple blank check approach to making their problems go away is out of the question. The next logical choice was to just loan them the money in exchange for some type of promise to pay it all back like they’ve done many times before, but the resulting debt burden would have been overwhelming, and as the experience of Greece has taught, unpayable debts not surprisingly end up not being paid, so a new solution was required.

The agreement, finalized during the all night haggling session, includes: 1) a 10 billion euro financing package; 2) 1.4 billion to be raised from asset sales, increased revenue from a hike in the corporate tax rate from 10% to 12.5% and a write-down in the value of the stake held by junior bond holders; and finally 3) a 5.8 billion euro “tax” on bank deposits. Specifically, a 9.9% levy of all deposits over 100,000 euros will be imposed, and 6.75% of all deposits below 100,000. Banks are closed until Tuesday (Monday is a national holiday), electronic transfers have been halted, and the amount of the levy within accounts has already been frozen. In exchange, depositors are expected to be given equity in their bank, equal in value to their deposit levy. Items one and two are tried and true components of all the past bailout arrangements, however the deposit tax is uncharted territory, and this is where the idea of precedent may end up being a double edged sword.

Banks have four primary sources of funding:

  • deposits
  • capital markets
  • other banks
  • central banks

Of these, deposits are considered to be the most attractive as they are the lowest cost (think what interest rate you get paid on your savings account) and tend to be stable. Depositors are typically considered to be sacrosanct when banks get into trouble because it is considered such a critical source of bank funding, but more importantly, because we need to have a home for savings that is inviolate, that we can rely on without question to secure the essentials of our daily lives. This is why the U.S. offers FDIC insurance for deposits, so that we can be sure that the sanctity of our savings are not subject to the vicissitudes of any one bank’s fortunes, or even those of the industry as a whole. In fact, during the 2008 credit crisis, when the U.S. government was forced to bail out the banking system to prevent complete implosion, insured deposit limits were actually RAISED to further guarantee the sanctity of savings. Even in the bailout of the Irish banking system, which was a multiple the size of GDP comparable to Cyprus, haircutting depositors was never considered.

What precedent does this decision set for depositors in other EA countries? Do you believe official assurances that Cyprus is a unique case will be comforting and that the trust and faith of depositors in other peripheral nations will be completely preserved? The danger here is that deposit flight out of the at-risk peripheral countries, which had just recently begun to abate, will begin anew and the fragility of the EA banking system will manifest itself once again. Officials are certainly keenly aware of this risk and are going to great lengths to convey that this is a unique circumstance and will not be replicated elsewhere. The language is cagey however and I would argue, leaves some wiggle room, a fact that is sure to be noticed by EA depositors. To be fair, the circumstances are in fact somewhat unique. The low tax rate in Cyprus has made it a favored tax haven for foreigners, so insulating depositors was seen as bailing out wealthy tax evaders, particularly in Russia and the UK, with taxpayer funds. This provides some justification for the levy of balances above 100,000 (even the FDIC sets insurance limits), but certainly not below. Further, likely to help soften the blow, while the one hand taketh away from depositors, the other hand doth giveth in the form of an easing of the terms of the bailout loans to Ireland and Portugal. Not of much comfort to Cypriots, but will likely be seen as somewhat offsetting good news for the rest of peripheral Europe.

This discussion of depositors is not to say that burden sharing isn’t appropriate. All investors in the capital structure of a bank (debt, equity and all the myriad combinations thereof) that knowingly assumed the risk/reward tradeoff of their investment should be forced to bear the consequences of failure just like they do in the event of bankruptcy in any other industry. If some type of government (taxpayer) guarantee of stakeholder claims is mandatory for the functioning of the banking system, then some type of compensation is due the government (taxpayers) for providing that guarantee. Currently no such compensation is provided. Depositors aren’t investors however. They are paying for a service. The low (or zero) interest rate paid on savings and checking accounts is basically the fee charged for providing access and security. Providing investors with a pro-rata equity stake based on seniority in whatever value remains in the failing bank is completely appropriate. Doing the same to depositors is not.


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