Saturday April 6, 2013

Cyprus bail-out turns bail-in


A Cypriot man holds a sign during a demonstration in Nicosia on April 02. Cyprus is a place where people hide their wealth from both taxmen and regulators. —AFP A Cypriot man holds a sign during a demonstration in Nicosia on April 02. Cyprus is a place where people hide their wealth from both taxmen and regulators. —AFP

CYPRUS blinked! A bail-out designed to rescue Cyprus and keep it in the 17-nation eurozone badly backfired a fortnight ago. The European deal agreed to in the wee-hours of March 16 in fact “bailed-in” all bank insured and uninsured depositors alike of this Mediterranean midget (population: 800,000), with a gross domestic product (GDP) of only 18 billion euros or equivalent to less than 0.2% of eurozone's total output. The 9.9% tax levied on deposits exceeding 100,000 euros (European Union guarantee threshold) alienated Russia (one-third of total deposits held by its businesses and banks). The 6.75% tax on guaranteed deposits sparked such outrage that even when later sweetened with an exemption for deposits below 20,000 euros, the rescue was voted down 36-0 by Parliament on March 19.

Cyprus may be bankrupt, but this was a messy deal. Eight months after the European Central Bank (ECB) had managed to restore some semblance of stability by promising “to do whatever it takes” to save the euro, the risk of exit by a euro member returned. Indeed, it raised the chances of bank runs if Cyprus can grab your savings, why not Italy or Spain? It just reflects the lack of real progress towards a durable solution to euro's woes. I think it's wrong for the eurozone to even consider letting tiny Cyprus slide out so easily. Euro's stability must rest on its irreversibility. Already, eurozone is in recession. Protest parties are getting more popular and more aggressive again. The real surprise was the International Monetary Fund's (IMF) support for a “hair-cut” on guaranteed deposits a sure sign of double standards. The IIF (International Institute of Finance, representing the world's largest banks) calls the move an “incredibly dangerous precedent in that it broke with practices that depositors' savings were guaranteed.” In so doing, eurozone breaks its own financial system's last great taboo. The consequences can be toxic.

Cyprus is unique

I well recall in the early stages of the European crisis, eurozone's preferred solution was to lend governments money to bail out holders of financial assets (e.g. bank bonds), thus passing the burden to future generations of taxpayers (moral hazard). Over time, as the debt burden ballooned and public finances became less sustainable, this approach softened. In Greece, part of the burden was shifted to private holders of government bonds. In Spain, Ireland and Netherlands, losses were inflicted on junior bond-holders. On each occasion, alarms were raised that imposing losses on investors could trigger contagion. But each time, the euro survived. Now, eurozone has gone one-step further by imposing losses on depositors, with the familiar warnings of impending doom. It is said Cyprus is unique because its debt (comprising mainly large bank deposits) is overwhelming. Combined assets of its two largest banks totalled 85 billion euror or five times GDP), with total deposits of 58 billion euros at the end of 2010. To get a sense of what this means relative to the US size, total deposits with these two banks alone would translate to the equivalent of US$45 trillion (actual deposits with all US banks totalled only about US$9 trillion). In a sense, Cyprus had become two banks with a country attached! This business model cannot survive. Even after the severe “hair-cut” on large depositors, Cyprus still requires a 10 billion bailout, equivalent to 60% of GDP. Cypriot banks are overwhelmingly deposit-funded, invested mainly in Greece. The nation is bankrupt. Its debt (including bank liabilities) would hit 145% of GDP. The choice was really between hitting big depositors or hitting eurozone taxpayers. For Germany and IMF, the choice is obvious. Cypriot politics too played a role it's scaring away offshore cash that has flown in to take advantage of its weak money-laundering enforcement. Basically, Cyprus is a place where people (especially Russians) hide their wealth from both taxmen and regulators. Then there is the delicate gap in trust and political cultures between northern and southern Europe. This lack of convergence keeps holding them back.

A bitter deal

With a failed deal at home, the EU and IMF stepped up pressure on Cyprus to seal a bailout worth 10 billion euros, provided it raised another 5.8 billion euros through re-working the bank levy to shelter all depositors below 100,000 euros each, EU threshold for deposit guarantee. ECB's emergency funding for Cyprus expired on March 25 the first time ECB publicly declared removal of a member state's banks from emergency lending support by the Euro-system (i.e. ECB and eurozone's 17 central banks). With its two largest banks already insolvent, Cyprus' financial would collapse without continuing access to euro-central bank funding, threatening its euro-membership. Cyprus was left with Hobson's choice. In the end, it clinched a last-ditch deal that would unlock 10 billion euros of troika (EU, ECB and IMF) money in exchange for:

● imposition of steep losses on uninsured depositors (including wealthy Russians);

● closure of Cyprus second largest bank to avoid a financial meltdown; and

● protection for guaranteed deposits (up to 100,000 euros each); radically restructure Bank of Cyprus, recapitalising it at 9% through a deposit/equity conversion; freezing temporarily uninsured deposits at its largest bank; and strict (again temporary) controls on money transfers and withdrawals and on capital transactions to prevent bank runs.

As I see it, the deal averts calamity of a disorderly default and a euro exist but at a high price. Indeed, the terms of this deal appear tougher than even the original proposal which clearly breached the spirit of EU's mandated deposit guarantee, rejected by Parliament. No doubt, it dealt a severe blow on Cyprus as an offshore financial centre. Drastic shrinking of the financial sector (18% of GDP) will have a profound impact on the domestic economy, predicted to contract by up to 10% in 2013. Like Greece, Cyprus will suffer a massive implosion without being able to devalue. This could prove intolerable. Given the scale of the shock, the troika has indicated readiness to allow Cyprus more time (until 2018) to bring its budget to a surplus. Small wonder. The main downside risk rests on the severe loss of confidence, very likely needing further bailouts to help rebuild its economy. Cyprus is expected to enter the same downward spiral that led other bailed-out economies (Greece and Portugal) to shrink dramatically, while strict money controls in and out would further restrain economic activity. In all, Cyprus faces an immediately painful, deep recession and years of hardship.

It has now become clear that the “hair-cut” on unsecured depositors can be as much as 60%: 37.5% to be converted into bank shares, and another 22.5% to be temporarily frozen to facilitate real bank recapitalisation. But the remaining 40% of deposits exceeding 100,000 euros each will be temporarily frozen to ensure the bank remains liquid; it will attract interest at 10% above current levels. This “bail-in” won't apply to Bank of Cyprus' depositors below the 100,000-euro threshold. Realistically, winding-up or restructuring a bank takes lots of time. In practice, deposits and other liabilities are converted into claims on the bank's assets. Liquidators sell the assets and repay claims piecemeal. Bank of Credit and Commerce International collapsed amid fraud in 1991. After two decades, creditors received an average 80% of their claims. Iceland's big banks collapsed in 2008. They are still paying off creditors. Its major bank (LBI.hf) is likely to complete payments by 2017. Make no mistake, it's a long haul.

Cyprus euro not the euro

For the first time, the euro bailout was accompanied by capital controls to avert bank runs and potential economic collapse. Two types of controls were instituted: curbs on domestic transactions (limits on cash withdrawals, cashing checks, card payments, redeeming time deposits, etc.); and cross-border capital flows (limits on cash take-outs and transfers, on funds for studying abroad and travel, etc). These are safeguard measures to preserve systemic stability. Experience has been that money curbs are easy to impose but tough to lift. True, some of these controls are now being eased to soften the blow. It will take time. Iceland still maintains capital controls five-years after its crisis. The key rests on rebuilding confidence. This is tough. It is also true Cyprus faces a run on its banks, not on its currency. Yet, capital controls create in reality two euros. Common currency is based on the concept that the euro held in one country is the same euro everywhere else. When this trust is broken (as in Cyprus), the Cypriot euro isn't the same as the Greek or German euro; it has since become second class. That's reality. Euros trapped on the island are less valuable than euros that can be freely spent anywhere. Even now, insured depositors are wondering whether they will be better off keeping their savings away from the banks and Cyprus in the event controls are ever lifted.

The eurozone has now entered risky territory. Capital controls run counter to EU's guarantee of free capital movement across borders. In a sense, Cyprus has in effect “withdrawn” from the euro once it imposed capital controls. After all, depositors elsewhere in Europe too could someday face strictures on capital movements. It brings home the reality of convertibility risk within eurozone. Economists polled recently stated that “this represents a uniquely bad deal for the euro's future.” Further, the majority singled out Spain and Slovenia, and possibly Italy, as the next likeliest candidates for a bailout. A handful cited Malta, France and again, Portugal. It's clear this bailout won't be the last.

What, then, are we to do?

The Financial Times summed up the underlying issue best on March 26 following the Brussels-Nicosia deal: “Eurozone shifts burden of risk from taxpayers to investors.” Yes, it's the first euro bailout to impose losses on bank deposits. The March 25 deal, including restructuring of Cyprus' two largest and baddest banks, would save EU taxpayers some 7 billion euros. Is this the new rescue template? As suggested by Jeroen Dijsselbloem, Dutch finance minister and Eurogroup chairman, who said: “You took the risks, now you pay for your thrills; no more moral hazard.” He later back-tracked to emphasise: “Cyprus is a specific case with exceptional challenges which required the bail-in measures macroeconomic adjustment programmes are tailor-made to the situation of the country concerned and no models or templates are used.” Be that as it may, it raises a fundamental economic issue: how much of a precedent has been set for future EU bailouts? How much of the Brussels' deal reflected German politics (Merkel faces an election and doesn't want to tell Germans they had to rescue the huge deposits of Russian oligarchs)? Where does this leave depositors once the politics is over? But there will always be politics. Mind you, depositors don't run banks; they really have no say. The forced transfer of large deposits into bank equity is unfortunate collective punishment. It is a stark reminder that banks do fail, and uninsured deposits are subject to the limits of government patronage in the face of moral hazard.

The rules of capital restructuring starts with equity taking the first loss, then bond holders and other creditors, with unsecured deposits the last to suffer. Since the crisis, the United States and Europe have handled bad banks by sheltering creditors and depositors from the consequences of their risk taking ways that enabled them to take on more and sillier risks with moral hazard. When unsecured deposits were hit in Cyprus, a line has been crossed. Yet, of the 147 banking crises since 1970 tracked by IMF, none inflicted losses on all depositors, irrespective of the amounts they held and the banks they saved with. Now, depositors in Spain and Italy have every reason to worry about sudden raids on their savings. In the end, banks will need to hold a layer of loss-absorbing senior debt, designed to spare all depositors, in all but the last resort. Here, the Volcker rule (which bars deposit taking banks from trading i.e. taking undue risks, with their own capital) can act to reduce risk-taking by deposit takers. In the final analysis, protection of depositors secured and unsecured can only come about with the creation of a proper banking union and some form of mutualisation of sovereign debt. There is just no other way.

Former banker, Tan Sri Lin See-Yan is a Harvard educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email:

  • E-mail this story
  • Print this story
  • Bookmark and Share