It is only weeks since European officials openly congratulated themselves on their seemingly successful efforts to bring the prolonged euro zone crisis to an end.

The backslapping subsequently proved premature, as the botched rescue package – designed to help an ailing Cyprus raise part of its emergency funding needs internally and ultimately secure external support of some €10 billion – put policymakers' incompetence on show for the entire world to see.

The initial proposals are difficult to fathom, given that policymakers had months – and not days – to devise a credible plan. The lack of time pressure should have allowed decision-makers to get ahead of the crisis, but this advantage counted for nothing as the proposed plan to recapitalise the banks was virtually certain to prove dead on arrival, given that it violated the hierarchy of claims in the capital structure.

The original plan envisaged that senior bonds would be made whole, while uninsured deposits would participate in losses, even though these depositors should rank at least pari passu [ranking equally] with senior bondholders.

Moreover, Cyprus’s leadership – in a desperate attempt to minimise the losses imposed on uninsured foreign deposits, and thus preserve the country’s status as an offshore banking centre – decided to bail-in insured depositors, even though such liabilities should be considered sacrosanct so as to avoid bank runs.

It came as little surprise that the deeply-flawed plan – intended to raise €5.8 billion and fill the hole in bank balance sheets left by bad debts and losses on Greek sovereign debt – was rejected by parliament; not a single member voted in favour of the proposals.

Orderly bank resolution

Sanity ultimately prevailed and the revised plan unveiled eight days ago resembled what one would hope to see in an orderly bank resolution.

The revamped scheme scrapped the ill-advised idea to impose a “stability levy” on all depositors, and will “safeguard all deposits below €100,000”. Instead, the banking system will be restructured. The Laiki, or Cyprus Popular Bank, the second largest lender, is to be split into a “good” and “bad” bank, with the former backed into the country’s largest lender, the Bank of Cyprus, and the latter wound down.

Laiki’s shareholders and bondholders – junior and senior – will be wiped out under the revised plan while insured deposits, alongside the €9 billion in liabilities that stems from liquidity support provided by the European Central Bank (ECB) and the national central bank, will be transferred to the Bank of Cyprus.

Laiki’s uninsured deposits amounting to €4.2 billion will be placed in the “bad” bank. These depositors can reasonably expect to recoup little, if anything, as they will receive a sum that amounts to no more than the distressed value of the “bad” bank’s impaired assets.

The enlarged Bank of Cyprus will face a large restructuring effort to raise its capital ratio to the EU-mandated 9 per cent by the end of the programme. Since no bailout funds are to be used to recapitalise the troubled bank, shareholders and bondholders are likely to lose all of their investments – while the hit to uninsured depositors, via a deposit-to-equity conversion, could amount to 50 per cent.

Far-reaching consequences
The revised plan is a vast improvement on the initial policy blunder, since it respects established credit hierarchy. However, there are still reasons to believe the Cypriot

crisis is far from resolved. The new blueprint could well have far-reaching consequences across the monetary union that are decidedly negative.

The banks have reopened with no sign of a run, but this was purely a function of the €300 daily limit on withdrawals and curbs on cashing cheques. These measures – alongside controls that prevent virtually any cash from leaving the island – are supposed to be temporary and last just seven days. However, once lifted, panic is sure to ensue as depositors scramble to protect their savings.

The banking system has already lost access to normal ECB operations and is dependant upon emergency liquidity assistance (ELA) from its national central bank. A shortage of unencumbered collateral – alongside the haircuts the national central bank applies – will limit the availability of ELA, which may prove insufficient to fill the gap left by deposit flight. Consequently, further losses could well be imposed on uninsured depositors.

As a result measures are likely to prove anything but temporary and remain in place far longer than envisaged. This should serve as a warning to bank creditors in other euro zone states with ailing and oversized banking systems.

Depositors – insured and uninsured – are sure to be nervous and willing to withdraw cash at the first hint of trouble.

Moreover, bank funding costs are likely to rise permanently for troubled banks. The decline in margins and the resulting downward pressure on profitability could well prove to be a key factor behind accelerated deposit flight.

The precedent set in Cyprus could have repercussions for years to come. Cypriot banking woes are a game-changer.

charliefell.com