the Cyprus bank crisis solution

the bailout

Over the weekend the EU and IMF came to agreement with the government of Cyprus on the shape that the rescue of Cyprus’ failing banks will take (I wrote about the overall situation late lase week).  The banks themselves remain closed, as they have been for ten days.

The highlights, if that’s the right word to use:

–the smaller of the two main Cyprus banks, Bank Laiki, will closed down.  It will be separated into a “good” bank, which will contain all insured deposits (those of €100,000 or less), and a “bad” bank, which will contain everything else.  Deposits in the former are safe.  Deposit and bond holders in the latter will get whatever’s left after the bank’s dud loans are settled.  That could well be close to zero–and, in any event, large depositors will have lost access to their funds for a considerable period of time.

–the Bank of Cyprus, the bigger bank, will remain open.  This is a face-saving concession insisted upon by the Cyprus government.  Uninsured deposits will be used to cover the losses on the bank’s loan book, with uninsired depositors losing as much as 40% of their money.

it’s Cyprus’ best alternative

The country’s recent prosperity is due mostly to the access it allows to the rest of the EU, and its less than diligent attention it pays to the provenance of the bank deposits it accepts.

The rescue injects €10 billion of EU/IMF money into the Cyprus banking system.  Cyprus also gets to remain in the EU.  Otherwise, it would still have the same large bank loan losses, but be €10 billion poorer and out in the cold.

Some commentators are saying that the losses that uninsured deposits in Cyprus will suffer will undermine confidence in the banks in other EU countries, like Italy or Spain.  I don’t think so.  The Cyprus story–crazy bank lending, deposits of dubious origin, tax haven–is well-known throughout the EU.  If anything, the union was hamstrung in its efforts to bail Cyprus out by how well-known the story is–and, in consequence, how politically unacceptable an outcome where Cyprus escaped very significant hardship would be.

The main result of the Cyprus episode, I think, will be to give the EU a significant push toward unified EU bank regulation.

 

my take on the Cyprus financial crisis

background

Cyprus is a Mediterranean island-state with a population of about 1 million and an annual nominal GDP of around US$24 billion (€18 billion).  The country joined the EU in 2004.  At that time, the union was still in a phase of wanting to be all-inclusive.  But even so, perhaps the only member enthusiastic about Cyprus’s entry was Greece, because of the two nations’ close business and ethnic ties.  As I understand the situation, it took a Greek threat to blackball other prospective members, like Poland, before Cyprus was allowed to slip in the door.  Cyprus joined the eurozone in 2008.

Why the reluctance?

Low tax rates have given Cyprus a long-standing reputation as a tax haven.  But after the collapse of the Soviet Union and the subsequent efforts by the nomenklatura in member countries to abscond with the national wealth, Cyprus is thought to have welcomed the cash of all comers, without being overly finicky about the source or legal status of the tidal wave of money it was receiving.

With its entry into the EU, Cyprus began to exert an even greater magnetic attraction for wealthy Russian immigrants seeking citizenship–and the access to the rest of the EU that a Cyprus passport would bring.  Deposits by foreigners into banks in Cyprus also ballooned.  About 40% of the almost €70 billion in bank deposits the Cyprus banks are thought to hold, are estimated to be from foreigners, most of them Russian.

How did the banks get into trouble?

The influx of cash gave them more money than they knew what to do with.  So they lent  …crazily.  A large chunk of loans went to Greek businesses, and a lot more was “recycled” into Russia and other parts of the old USSR.  The banks bought a large helping of Greek government bonds, as well.  And they funded a local property bubble.

How bad is the situation?

from Cyprus’s point of view

Because of the way they operate, the banks in Cyprus are gigantic in relation to the size of the country.  To get a sense of how big, consider the United States.  According to the Federal Reserve, the total of deposits in commercial banks in the US is $9 trillion, give or take, or about 58% of GDP.  Deposits in Cyprus banks are almost 4x that country’s GDP.

The bailout of the Cyprus banking system proposed by the European Central Bank and the International Monetary Fund is €17 billion.  Of that, €10 billion is supposed to be coming from the EU/IMF.  The other €7 billion is supposed to come from Cyprus–an amount that’s almost 40% of GDP.  Where can/will Cyprus get its share of the money?

A standard remedy for banks facing default would be to go to their lenders and ask they to take a (huge) haircut on their loans.  That’s what Greece ultimately did.  But the Cyprus banks are like giant cash machines.  They haven’t needed to borrow; they have almost no lenders to share the pain with.

The government could raise taxes–but it would have to be a whopper of an increase to make a dent in the funds needed.  And Cyprus’s government finances are  already in bad shape.

So the obvious (read:  only) source of bailout funds is uninsured customer deposits.

Hence, the plan to “tax” these deposits to get Cyprus’s share of the bailout money–offering equity in the restructured banks in compensation.  The way the tax is structured, it seems to hurt ordinary citizens and spare the oligarchs.

from the rest of the EU’s

In the overall scheme of the EU bank rescue, €17 billion is a trivial amount of money.  It’s something like a week’s interest expense on aggregate EU government debt.  But there’s a principle involved.  And there’s a related political issue.

In principle, a country that fails to supervise its banks and mishandles government finances shouldn’t simply be rescued without any contribution of its own.  Also, the biggest beneficiaries of any bailout would be what many regard as Russian criminals laundering their money through the Cyprus banks, with Nicosia complicit.  Understandably a hard sell throughout the EU–or anywhere else.

where to from here

The banks on Cyprus will be closed until some time next week, as the parties work toward a solution.  The main stumbling block sounds like it’s Nicosia’s desire to protect the golden goose of Russian money flow.

Stock market worries have been centered around the possibility of a run on banks in, say, Italy and Spain, if depositors in Cyprus lose part of their principal.  Part of the panic was sparked by economic “experts” who are recognizable names and who churned out the initial reports on late weekend’s bailout negotiations.  I think these pundits reacted to the headlines without knowing many of the facts.  It’s not that I’m an expert on Cyprus–I’m not.  But it’s pretty easy to detect when interviewees are talking through their hats.

The worst case solution for Cyprus would be that its major banks fail and the country is forced to leave the EU.  Very bad for Cyprus.  Almost no one else in the EU would notice.  Russian oligarchs wouldn’t be happy.

A run on other EU banks?  Unlikely, in my view.  The facts in the Cyprus case are very unusual, given the dubious character of its banks.  And the pressure on the EU not to simply throw money at the problem and make it go away is coming from ordinary citizens elsewhere in the EU who have their money on deposit locally.  They seem to see a big difference between their home country institutions and those on Cyprus.  I think they’ll continue to do so.

a wild card

Russia has previously made a bailout loan of €2.5 billion to Cyprus to prop up its banks.  Discussions are apparently underway between Moscow and Nicosia for more aid.  One plan being would have Cyprus grant Gazprom oil and gas exploration rights in return for, say, taking over one of the big insolvent Cyprus banks.