After a week of threats, protests, and alarm in financial markets, Cyprus and its bailout partners reached a deal early Monday morning that was far better than the outcome negotiated earlier in the month. Instead of socializing the costs of their failure across the entire Cypriot population, Cyprus and the Troika (consisting of the European Commission, the European Central Bank and the International Monetary Fund) reached a far more focused accord concentrating the financial losses on the customers and creditors of Cyprus's two problem banks. Their agreement vastly improved the previous week's arrangement, which would have raised €5.8 billion from a levy on all depositors in Cyprus, including insured depositors below €100,000, in order to qualify for a €10 billion IMF program. The bailout money was to have been used in part to recapitalize the two large Cypriot banks, whose financial losses would have been spread out across all Cypriots and quite a few foreigners with bank accounts in the country.
Ironically, the euro area can thank the Cypriot parliament and Russia for rebelling the first time around, thereby backing the Cypriot government into a corner and averting the Troika's initial policy mistake of acceding to the Cypriot government's demands to impose the levy on insured deposits. Cypriot lawmakers rejected the depositor levy in order to limit the financial impact on Cyprus' two large banks. Russia's refusal to provide new money, combined with an European Central Bank (ECB) ultimatum to Cyprus to reach a deal by Monday or face removal of emergency liquidity assistance for its banks, left Cyprus with no options but to take a deal it had earlier rebuffed, calling for restructuring of the two Cypriot banks.
A Look at the Details of the Deal
The new deal includes some elements of the original arrangement: a €10 billion bailout, a downsizing of the Cypriot banking system to the euro area average by 2018 (implying a 50 percent deleveraging); increases in the Cypriot corporate tax rate and withholding tax on capital income; and new actions against money laundering. Several other elements were added, improving the terms from Europe's perspective. Rather than using the depositor levy to finance a recapitalization of problem banks, the plan now calls for the Laiki Bank, the weakest of the two troubled banks, to be liquidated—with the full cost borne by shareholders, bond holders, and uninsured depositors—and split into a good and bad bank. The "good bank" is to be merged into the other troubled institution, the Bank of Cyprus. Shareholders, all bondholders, and almost all uninsured depositors in Laiki Bank will likely be wiped out. The Central Bank of Cyprus, which has extended $9 billion in emergency loans to Laiki Bank, will be fully protected from losses, as its loan will now be transferred to the Bank of Cyprus.
(The costs imposed on creditors were carried out in a manner that Ireland might wish it had done with creditors of the bankrupt Anglo-Irish Bank in late 2010. Whether this deal will affect future dealings between Dublin and the euro area is unclear. As compensation, Ireland will probably get a longer maturity for its earlier loans from the European Financial Stability Facility.)
Meanwhile the large uninsured deposits in the Bank of Cyprus—many of which are thought to be Russian—will be frozen until it can be determined how much capital is needed to achieve a capital ratio of 9 percent at the end of the IMF program. The Bank of Cyprus's recapitalization will take place through a deposit-to-equity conversion of uninsured deposits, with full costs again borne by equity shareholders and bond holders. Shareholders and at least junior bondholders in the Bank of Cyprus will also likely be wiped out, while some large deposits will convert into bank equity. Senior bondholders in the Bank of Cyprus may escape full losses because the bank is being restructured, not dissolved.
Transcending these complicated arrangements is an important political distinction: Only Cypriot bank deposits will be used to recapitalize the Bank of Cyprus. The Troika loans go only to the Cypriot government, meeting Germany's determination to avoid using taxpayers' money to bail out or recapitalize banks that German voters—and indeed most Europeans—view as reckless in condoning money laundering and tax avoidance as a business model.
Important Implications for the Euro Area
The Cyprus deal sets important precedents as the euro area establishes a single resolution mechanism for troubled banks in the future. First, it suggests that the requirement of bank bondholders taking losses ahead of taxpayers—as undertaken with regard to Irish banks by the Irish Bank Resolution Corporation (IBRC), as discussed here on RealTime some time ago—has now arrived in the euro area. All junior and senior bank bondholders in Laiki Bank (and probably the Bank of Cyprus) will be wiped out. Thus from now on in systemic banking crises, bondholders, including senior bondholders, should expect large losses under the euro area's new Single Resolution Mechanism to be negotiated later this year.
The euro area president, Jeroen Djiesselbloem, has effectively endorsed this interpretation. As discussed on RealTime, the coming euro area banking union will not tolerate frequent bank bailouts via direct bank recapitalizations by the European Stability Mechanism. Rather it will be creditors who are asked to bear the cost, otherwise known as a "bail-in." As Djiesselbloem told Reuters:
Now we're going down the bail-in track and I'm pretty confident that the markets will see this as a sensible, very concentrated and direct approach instead of a more general approach…It will force all financial institutions, as well as investors, to think about the risks they are taking on because they will now have to realize that it may also hurt them. The risks might come towards them.
Regrettably, the Dutch eurogroup president later modified this comment, calling Cyprus "a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday." I see this as a clumsy retraction indicating that he did not want to upset financial markets or influence the next phase of negotiations over bank resolution in Europe.
Actually, by protecting insured deposits below €100,000 in Cyprus, the deal this week—however messy it was—has rendered insured deposits in the euro area safer than ever. No euro area policymaker will dare touch them in the future. Indeed, the political motivation to create an integrated euro area deposit insurance scheme will grow.
In the process, the euro area continues to move in fits and starts toward a banking resolution creditor ranking resembling the model of the Federal Deposit Insurance Corporation (FDIC), in which insured deposits are protected while losses are imposed on shareholders first, then on junior and senior bondholders, and then on uninsured depositors. This ranking has not yet been codified in Europe, but the Cypriot outcome is similar and sets a precedent as the euro group president indicated.
The demand that Cyprus reduce the scale of its banking system to the euro area average size of 350 percent of GDP—from its previous level of 800 percent—also means that an absurdly oversized banking system will not qualify for a future direct recapitalization from the European Stability Mechanism. Luxembourg and Malta should take note. Both have banking systems at least as large as that of Cyprus as a share of national GDP. (Luxembourg's is three times bigger!) They await Cyprus's fate if they need help in a future systemic banking crisis. Bank regulators in Malta and Luxembourg will hopefully be more diligent than in Cyprus, where shifting of blame to others won sympathy in gullible English language newspapers.
The Future Sustainability of Cyprus
A question remains whether Cyprus should have said "yes" to the first deal of March 16. Probably so. While this new deal is better on the merits, for Cyprus it represents a surrender on its earlier demands that no depositor levy be included. The plan to convert big uninsured deposits in the Bank of Cyprus into bank equity embodies some of the attractions of the first deal's imposition of losses on non-residents, most of them Russian.
One concern shadowing the future of Cyprus's domestic economy, however, derives from the capital controls it had to impose. Though the target was only the two problem banks, the entire Cypriot banking system will suffer a stigma. If the bank restructuring is implemented swiftly, capital controls in the broader economy need not last for long, even as two problem banks remain inaccessible. The Cypriot government is responsible for this outcome, although the Troika is culpable for having acceded to it by initially agreeing to impose the depositor levy on also insured depositors. Capital controls might have been avoided if Cyprus had sold one of its problem banks to Russia in 2011 or 2012 as part of an IMF program. But such is history. The euro area has not had the authority to take over a bank, shut it down and reopen the remnants with little impact for retail depositors, as the FDIC does in the United States. A new single resolution mechanism in Europe should obviously have such a capacity if capital controls are to be avoided in the future.
The comments of euro area officials at a press conference after the negotiations underscored the political nature of the IMF debt sustainability analyses (DSA). While having few firm insights into the longer-term macroeconomic effects of this new agreement on Cyprus, the euro group president and the managing director of the IMF said its peak debt load would reach "around 100 percent of GDP." The hard numbers in the Cypriot (or any) DSA are a smokescreen for a qualitative and political assessment of the actual measures agreed with the IMF/Troika. They tell little about the effects on growth and debt sustainability. If the host government makes a positive political assessment, the DSA results will conform to that conclusion. No one in the Troika has an idea what is going to happen to the Cypriot economy. The DSA is merely the IMF's way to hide the fact that forecasting is an impossible task.
The Cyprus saga—for all its messiness—reflects the progress made by the euro area since last year. Despite the hopes of the usual euro Cassandras in the financial media that their projections of doom would come true, global financial markets have shrugged off the Cyprus crisis. There was not even a hint of the frequently predicted retail depositor bank runs in other euro area countries. Cyprus has actually vindicated the increased resilience of the euro area this year.
How the financial markets react to the implications of Cyprus for the handling of future banking crises is a different matter, reflecting concerns that future financial losses will shift to investors from European taxpayers. Markets should have absorbed that lesson a long time ago.
Despite the happy outcome, will the Cyprus agreement aggravate the peripheral euro area credit crunch, putting more funding pressure on already stressed banks there? If so, short-term growth in the euro area could suffer later this year, hopefully spurring the ECB to extend a credit lifeline to peripheral banks and non-financial sectors. Frankfurt should now start to think about how to help through more non-standard measures, perhaps with purchases of securitized small business loans, corporate bonds, or other assets.
Ironically, the absence of market pressures allowed the ECB to issue its ultimatum to Cyprus this month. No longer frozen by panic in the face of market pressures, the euro is benefitting from the independence and political power of the ECB and its willingness to force policymakers to act. Thus the euro area crisis has evolved from a market driven to a more politically driven set of events, akin to the US fiscal crisis, which plods along without any noticeable market reactions, and instead is pushed by legislated "cliffs," sequesters, debt ceiling measures, and the like.
It is the German government that needs to take another political lesson from Washington, however. Berlin should not be shocked over being blamed for Cyprus, despite the fact that the Cypriot government, not Germany, sought to tax insured depositors and nationalize Cypriot pension funds. The hegemon always gets the blame. As the only grownup in Europe now, the German political class and media must develop a thicker skin.