Europe Stumbles to a Cyprus Solution

After several late-night meetings and considerable angst, the members of the eurozone have settled on something for Cyprus that looks very much like a typical bankruptcy. It is comical in a way that people worked so hard to arrive at an already widely known, well-established process. Still, this result may have value. Because Europe through these four years of crisis has strived to tailor settlements for each new challenge, it has always left people in doubt about each outcome, particularly where the pain would fall. The extreme uncertainty involved has raised the risk of failure by creating patches of destructive market turmoil. Perhaps now, by finally settling on what is after all long-standing practice, Europe at last may have found an outline for future challenges that, if it cannot banish all the pain of resolution, will at least relieve a measure of uncertainty.

The deal's fundamentals are clear enough.1In order for the government in Cyprus to receive European rescue funds, it will, effectively, have to collapse its financial system. The bond and shareholders of Cyprus's two largest banks will lose all. Depositors will get the protection of insurance up to the first €100,000. Thirty to 40% of the amounts above that will be converted into shares. The smaller insured deposits and viable assets of the island's second largest bank, the Popular Bank of Cyprus (also known as the Laiki Bank) will migrate to the Bank of Cyprus—an infusion of liquidity and assets that should make it viable. Meanwhile, the Laiki Bank will be dissolved. It is a classic "good bank/bad bank" model of resolution. The plan expects to raise €5.8 billion from the banks in this way, the majority, €4.2 billion, from Laiki Bank's larger deposits. The more authorities can get out of Laiki's depositors, the smaller loss they will impose on large depositors at the Bank of Cyprus. In return, the government will receive €10.0 billion in rescue funds from Europe, and the rump of Cyprus's financial system will remain eligible for the usual support of the European Central Bank.

This approach contrasts with past European settlements, which have relied more on taxpayer funds and savaged bondholders and depositors less. It is little wonder, then, that stock markets retreated initially when the plan was announced—and also responded badly to remarks by Netherlands' finance minister Jeroen Dijsselbloem that this practice should become the eurozone's default approach to ailing lenders.2But otherwise, the solution calmed market fears. The euro—which had fallen more than 5% against the dollar during the uncertainties preceding the settlement—stabilized, albeit at its low level. The rates on Italian and Spanish debt, which had jumped under the initial uncertainties, fell back to levels that prevailed before the crisis, as did the yields paid by other vulnerable members of the eurozone.3

While this approach offers a welcome predictability, it likely will instigate capital controls with all their negative consequences Depositors in Cyprus banks, having lost, will naturally want to withdraw what remains of their assets and place that them in safer locations. Finance Minister Dijsselbloem's remarks may convince depositors in other vulnerable nations to do the same thing. To block this disruptive flow, Cyprus and other peripheral countries will likely further capital controls to limit the amount depositors can withdraw or send out of the country. Such restrictions may only need to last a short time, until people's most intense fears dissipate. But even temporary restrictions will likely prevent the movement of funds to where they can best be used and so further stymie growth prospects. The controls are expected to also penalize depositors even more by enabling financial institutions to hold onto funds while paying a lower interest rate than they might otherwise. Worse still, capital controls in some member nations would raise questions about the universal nature of the euro, for euro deposits in places without controls will offer more value than those in places with controls.

However the details work out, especially on the question of capital movements, there can be no mistaking that Cyprus will suffer severely. There are, to begin, all the austerity strictures Europe will impose on government policy as a condition for the €10 billion in aid. These, with very little variation, have been a consistent part of the otherwise very different European rescues during the past four years. But more, this settlement, particularly its resemblance to bankruptcy, will utterly destroy Cyprus's economic model.4

But then, the island's model was never sustainable. Cyprus, largely through the Laiki Bank, had actively presented itself as a place for Russian oligarchs to bank and conduct their other business. The Cypriot government facilitated this business by establishing a thorough tax treaty with Moscow. Russia also supported the arrangement in 2011 by extending a €2.5 billion loan to the island nation. The flow of oligarch deposits, amounting by some estimates to as much as €28 billion in an economy of less than €20 billion, dangerously inflated the size of the financial sector.5For a while, the excesses of capital created a remarkable prosperity, as did the oligarchs' luxury living, fostering a jobs boom in finance, obviously, but also in expensive goods imports, tourism, and the hospitality industry. Some in the media have speculated that the special burden placed by the settlement on Laiki deposits aims at these oligarchs. Certainly, that was the initial response of Moscow. Russian prime minister Dmitry Medvedev referred to the settlement as "stealing."6But in the end, President Vladimir Putin signaled his acceptance by extending the official loan for five years and reducing its interest rate from 4.5% to 2.5%.7

A collapse in Cyprus, hard as it will be on the Cypriots, will do little to make matters much worse in the eurozone generally. Even Cyprus's inflated economy amounted to less than 1.0% of the eurozone as a whole.8Meanwhile, for all the drawbacks of capital flight and credit controls, this Cyprus solution, by drawing on something close to standard bankruptcy practice, offers some hope that Europe will handle future financial challenges better than in the past. By abandoning the tendency to create new procedures at each turn and instead relying on this familiar approach (not as a rigid template but as a guide), Europe may well avoid the unnecessary uncertainties and market turmoil of the past. The Continent is far from done with this crisis, but the relative calm offered by better understood, more predictable procedures would alone raise the prospects of success and make the authorities' jobs easier.

1 For detail on overall Cyprus plan, see, for example, BBC news summary, April 1, 2013; BBC news summary of March 25, 2013; and Nicholas Cecil, "Russia and Germany Clash Over Cyprus Bailout Deal," London Evening Standard, March 25, 2013.

2 "Top EU Official: Cyprus Bank Rescue New Template," Times Union, March 25, 2013.

3 Bloomberg.

4 Courtney Weaver, "Russians Prepare to Quit Cyprus," The Financial Times, March 25, 2013 and Scott Rose and Ilya Arkhipov, "Putin Warms to Cyprus Rescue with Order to Renegotiate Loan," SF Gate, Bloomberg News, March 25, 2013.

5 Ibid.

6 "Russia Backstops Cyprus Bailout Despite Anger," Reuters, March 25, 2013.

7 Rose and Arkhipov, op. cit.

8 See Weaver, etc., op. cit.

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