Calm has prevailed across the euro zone ever since Mario Draghi, the ECB’s president, promised last July “to do whatever it takes to preserve the euro”.
Draghi’s words were sufficient to end the capital market turbulence that threatened to undermine the euro, as investors came to believe the incompetence displayed by policymakers throughout the crisis was no longer an issue.
New-found confidence in policymakers appears to have been premature, however. The response to the Cypriots’ need for financial assistance almost certainly ranks as the biggest policy blunder so far. And no matter what amendments have been made to the deal, the original proposals could have far-reaching consequences.
Cyprus, with an economy that accounts for just 0.2 per cent of euro zone GDP, initially requested assistance to prop up its failed banking system last summer.
The banking sector expanded rapidly over the past decade and more, as the desire to become a recognised international financial centre saw banking sector assets jump to €126 billion, or more than seven times GDP, but the growth was accompanied by virtually no diminution in the traditional dependence on Greece, and this proved to be the banks’ undoing.
Greek residents account for more than a quarter of Cypriot banks’ loan portfolio – much of this exposure soured as Greece plunged into economic depression.
Greek sovereign bonds
Further, the banks have long been sizable investors in Greek sovereign bonds, and they suffered large losses following last year's managed default in that country. Indeed, Cyprus's two largest banks – the Bank of Cyprus and Popular Bank (Laiki) – held Greek bonds worth €4.7 billion at the end of 2011. Subsequent losses came to €3.5 billion – equivalent to 20 per cent of the country's GDP.
The losses incurred on Greek sovereign debt pushed Cyprus’s banking system over the edge, but the banks are simply “too big to bail” by the Cypriot government alone; the funds required for recapitalisation would push the public debt ratio up to unsustainable levels of close to 150 per cent of GDP. That would, in itself, precipitate a run on sovereign debt and virtually assure a restructuring in the not-too-distant future.
For this reason, the euro group was unwilling to provide the full amount Cyprus originally requested, and said the Cypriot state would have to pony up the remaining funds of some €6 to €7 billion.
Strapped for resources, a bail-in of banking creditors seemed the only viable solution, even though the banks’ capital structure presented unpalatable choices.
Unusually, the expansion of Cyprus’s banking sector was financed primarily through growth in the deposit base, with bonds playing only a minor role. Indeed, the most recent data show total deposits amount to about €68 billion, while bonds outstanding come to just €2 billion.
Untouchable liabilities
The balance sheet reality meant a viable recapitalisation plan might have to include the most untouchable of all bank liabilities: deposits.
This is what happened 10 days ago.
As part of the €10 billion rescue package agreed upon by the country’s leadership and the troika, European officialdom insisted Cyprus impose losses on depositors to raise funds of close to €6 billion. The final proposals included a once-off “stability levy” or wealth tax of 9.9 per cent on uninsured deposits – balances of more than €100,000 – totalling €38 billion, and 6.75 per cent on insured deposits – balances below €100,000 – amounting to some €30 billion.
The participation of depositors is unprecedented in the euro-zone crisis so far, and their inclusion now can be viewed only as a massive policy blunder, since it turns established credit hierarchy on its head. After equity is wiped out, a bail-in would be expected to impose losses on junior bondholders first, and then on senior bank paper. Uninsured depositors should reasonably expect to rank at least pari passu with senior bondholders, while insured deposits should be sacrosanct.
The proposals subverted the established order of subordination, with depositors discovering belatedly their claim ranked below bondholders in the liability structure.
Banks gather deposits that are low-risk, highly liquid and typically small in size. These claims are transformed into loans that are risky, illiquid and usually larger in size. The inherent mismatch means banks can fall victim to sudden, devastating bank runs; to avert such an outcome and enhance financial stability, governments provide deposit insurance.
The proposed default on deposit guarantees in all but name in Cyprus demonstrates complete irreverence for depositors. Most depositors are simply not in a position to monitor a bank’s activities, and this proposal increases the likelihood of liquidity crises elsewhere in the region on the slightest hint of bad news.
Cyprus's parliament voted against the proposals and, at the time of writing, alternatives were being considered. The damage has been done, however, and investors will remember the Cypriot crisis as the event that pushed policymakers' lunacy to unprecedented heights.
charliefell.com
