The decision in Europe to tax depositors in Cypriot banks, forcing them to share in the cost of the latest euro area bailout, has sparked anger in Cyprus and concern that a run on Cypriot banks could spread to Spain, Italy, and other troubled countries. But the so-called "stability levy" on all depositors, not even exempting those with small deposits, reflects the Willie Sutton rule. Bank deposits are the largest asset at the disposal of the Cypriot government. That is where the money was to support a rescue sought by all stakeholders. Taxing depositors also ensures that Russian depositors, who are believed to have used the Cypriot banking system for illicit activities and money laundering, will also share the cost.
As someone who has previously predicted and advocated this solution on RealTime, I believe that requiring depositors in Cypriot banks to share the financial burden of the country's financial rescue was the least bad option for Cyprus. Despite concerns about the repercussions, I would even argue that this step represents progress for both the euro area and the International Monetary Fund (IMF).
The broad details of the deal are:
- Cyprus will get a €10 billion bailout and a full multi-year IMF adjustment and reform program;
- A one-off levy of 6.75 percent is imposed on bank deposits under €100,000, and 9.9 percent above €100,000. In return, Cypriot depositors will receive an unspecified amount of equity in Cypriot banks and other sweeteners providing potential for future financial gains as an incentive to keep the rest of their money in Cypriot banks;
- There will be a new additional tax (of still unknown magnitude) on bank deposit interest income;
- Cyprus's corporate tax rate will rise 2.5 percentage points to Irish levels of 12.5 percent;
- Cyprus commits to shrinking the size of its banking system to the euro area average by 2018;
- This implies a dramatic deleveraging from today's levels of 700 to 800 percent of GDP to around 350 percent;
- Russia seemingly will contribute by extending the maturity of its €2.5 billion loan from 2011 by five years to 2021, and receiving a lower the interest on the loan;
- The IMF Board will likely agree to contribute financing to the bailout—presumably the usual one-third share in previous euro area programs.
For Cyprus, a Least Bad Option
The deal faces difficult prospects in the Cypriot parliament. But given the lack of an alternative, the package will likely pass largely unchanged, even if Cyprus has to go through a process in which parliament initially rejects the bailout, only to see financial markets react negatively and then change their minds. (The pattern is familiar, notably from the rejection and acceptance of TARP in congress in 2008.) Whether or not the package passes, a massive outflow of money from the Cypriot banks is inevitable in the coming days, though Cypriot lawmakers may seek a better way to compensate depositors than offering them bank equity. Perhaps direct stakes in Cyprus's future natural gas revenues or similar more promising long-term compensation will be conjured up. It may also be politically necessary to adjust the tax burden on depositor levies, perhaps exempting more small depositors, while increasing the cost to larger depositors.
Undoubtedly, the deal will damage the political standing of the newly elected president, Nicos Anastaciades. But Cyprus is broke, with few other alternatives. Russia, which has been a standby friend, will not lend more money without involvement by the European Union, the European Central Bank (ECB) and the IMF, known as the Troika. Cyprus could theoretically turn to neighboring Turkey, but might then face unacceptable political conditions, such as reunification of the island on Turkish terms.
Many will criticize the deal as unjust and lacking in euro area "solidarity," but Cyprus's financing needs are massive, estimated at €17 billion, or 100 percent of 2013 GDP. The €10 billion in financing for Cyprus represents 57 percent of GDP. This proportion matches the share of national GDP of the initial €130 billion program for Greece, and more than the 40 to 45 percent of national GDP for the multiyear programs for Ireland and Portugal.1 Cyprus thus actually gets more financial solidarity from its euro area partners than other crisis stricken members. Cyprus's banks lost their shirt on a big bet on Greek government bonds gone awry in a country with an economic model dependent on huge, poorly risk managed banks. It is not entitled to more European taxpayer help than other errant euro area countries.
The deposit levy, controversial as it is, reduces Cyprus's financing needs to a level in line with assistance provided other euro area members. It should be seen as functionally equivalent to the €17.5 billion (11 percent of Irish 2011 GDP) contribution to Ireland's IMF program by the Irish Treasury and the Irish National Pension Reserve Fund. Unlike Ireland, Cyprus does not have a national pension fund to draw on, so as stated earlier, policymakers went where the money is.
Indeed, the deposit levy should be seen as having advantages, mainly by expanding the Cypriot tax base to include Russians and other foreigners. The levy is expected to yield €5.8 billion, or 33 percent of 2013 Cypriot GDP. If half these deposits are foreign-held, Cyprus will extract 16 to 17 percent of GDP in extra tax revenue from foreign sources, lightening the burden on Cypriots and softening the blow of additional cuts in government spending, pensions, or other social services. Not only Russians but also quite a few British expats will have to pay, guaranteeing a hostile reception in the UK media.2 Cypriots should breathe a sigh of relief over this aspect of the deal.
The one-off levy also enables the national governments to retain full sovereignty with respect to its, avoiding legal complications from EU competition authorities or entrepreneurial lawyers acting on behalf of aggrieved investors and depositors. Of course, the levy is a depositor haircut, or "bail-in," by another name.
I was surprised that the tax applied to all depositors, including those insured below €100,000, a step no doubt taken to raise enough money and broaden the tax base.3 Had low-level depositors been exempted, Cyprus might have had to impose a 25 percent levy on large deposits, wiping out the working capital of small and medium enterprises (SMEs), damaging prospects for recovery and perhaps putting Cyprus' status as an offshore banking center at risk. Perhaps the Cypriot president—recalling Prime Minister David Cameron's example in Britain proclaiming, "We are all in this together"—chose to spread the burden rather than single out the wealthier ones. The choice, on the other hand, may backfire and President Anastaciades may have to adjust its terms to get it through parliament.
For the Euro Area, Toughness and Pragmatism
One lesson learned from the tax decision was that when the euro group agrees to meet on a Friday evening after banks have closed to discuss a bank bailout, it is advisable to take your money out of the bank beforehand. Beyond that, the deal sets a precedent that even insured deposits in extreme cases are potentially at risk. Even if the immediate impact is small, the deal does not help restore stability to the broader euro area banking system.
But the Cyprus deal does illustrate the political pragmatism of the euro area, which did what it had to do while minimizing the cost to taxpayers of bank bailouts. The motivation to spare taxpayers sheds light on how the permanent reforms of the euro area banking resolution framework will look. Cyprus has demonstrated that in a systemic banking crisis affecting an oversized banking sector in the euro area, even insured depositors rank lower than other euro area taxpayers. A clearer indication of priorities—bailing in bank investors to shield taxpayers—is hard to imagine.
The fact that only junior bank bondholdersface losses in Cyprus reflects the limited number of senior bank bondholders in the Cypriot banks. Because market turmoil would likely occur if losses were to be imposed on euro area senior bank bondholders, policymakers seem to have decided that imposing such losses was not worth the trouble. No doubt senior bank bondholders would have been hit with losses if there was enough money to be obtained from doing so. As with Ireland's recent deal on the Irish Banking Reconstruction Corporation (IBRC), this deal should make clear that imposing losses on bank bondholders (and even depositors) will be the new norm in the euro area banking union. The implicit government guarantee enjoyed hitherto by bank bonds will end. A new system similar to the Federal Deposit Insurance Corporation (FDIC) in the United States will replace it. Whether euro area policymakers are fully grasping the effects of this on the funding costs of euro area banks is an open question. There is a risk that these changes will aggravate the credit crunch in the short run in some euro area countries, where alternative funding sources from corporate bond markets are poorly developed. This is a particular concern for SMEs, of course.
More broadly, does the Cyprus deal cast an immediate shadow over all bank depositors in the euro area, especially in troubled countries? The answer is no.
That is because the Cypriot deal is not replicable. Cyprus's banking system represents 700 to 800 percent of GDP, a scale is not found elsewhere in the euro area. The lack of a sufficient number of bank bondholders available to take losses is also not found in any other euro area banking systems, which also are not shadowed by concerns of money laundering and murky Russian deposits.
Yes, fears of bank runs by depositors are now inevitable across the euro area, magnified by media in the United Kingdom and the United States, still recalling Northern Rock and bank runs in US financial history. But most of the alarmists are the same people who, since 2009, have predicted the imminent collapse of social order in Europe and a return to the politics of the 1930s. The fearmongers have been wrong on that, and they are wrong now. Ironically, the very fragmentation of euro area financial markets, economies, and societies in general—often cited as a barrier to progress—will prevent such contagion from spreading. Cyprus has too little in common with other euro area countries to cause drastic cross-border spillovers.
The Troika is mindful about the dangers. Accordingly, they shielded Greek operations of Cypriot banks from the deposit levy,4 removing a potential risk to the economic stability of Greece. They clearly see any risk of bank runs as manageable, though Cyprus will experience long lines outside the banks and the ECB will have to provide Cyprus with cash.
The ECB's role, as usual, is critical and interesting. As Ireland was forced to approach the IMF for a bailout in late 2010, Cyprus was subjected to behind-the-scenes pressure from the ECB in the form of threats to cut off liquidity support from the banking system if it did not accept a deal. According to President Anastaciades, the ECB had already decided to terminate liquidity provision to the two big Cypriot banks on March 19, provoking a disastrous downward economic spiral in Cyprus. The episode again illustrates the raw coercive political power of the uniquely independent ECB when dealing with stricken governments.
No less interesting is the ECB's switch of tactics. In Ireland in late 2010, the ECB prevented the Irish government from imposing immediate losses on bondholders in the collapsed Irish banks. It did so out of fear of destabilizing the euro area banking system further. This time, the ECB (and several euro area countries and the IMF) pushed for losses even on insured bank depositors. The shift means that the ECB is more sanguine about the euro area banking system's stability today than in 2010. Its tough approach and willingness to defy political establishments signals how seriously the ECB will take its role as banking regulator in the future. Europe's banking sector is now on notice.
For the IMF, a Positive Role
The IMF deserves high grades for its insistence on a sustainable program, in which Cypriot debt will rise to no more than 100 percent of GDP by 2020.
The depositor levy breaks the link between the Cypriot sovereign and the Cypriot banks, a longstanding IMF demand. Many had advocated a direct recapitalization of Cypriot banks by the European Stability Mechanism (ESM) as the way to sever the sovereign-bank link. But as discussed on RealTime, it is unrealistic to expect the ESM to operate as an insurance mechanism insulating national governments fully against the costs of a banking crisis, especially because Cyprus already benefits from substantial euro area financial support through the IMF program.
The IMF (and the rest of the Troika) further deserves credit for a decisive and early program. The deposit levy is to be implemented immediately, allowing for a quick shift by the government to spur economic growth. By contrast, Greece has been tortured by gradual and piecemeal cuts and reform measures.
In sum, the Cypriot deal should ultimately benefit everyone. Even Chancellor Angela Merkel of Germany should be pleased to be protected from campaign attacks of being too lenient on the banking sector. Cypriot political leaders will, however, suffer as always, getting little credit from avoiding a worse outcome. Cyprus has avoided a worse fate, for sure.
One last downside to the deal, however: Nicosia has avoided European leaders using their leverage for an additional step—to promote the reunification between the Greek and Turkish sides of the divided island. They may come to regret that in the future.
1. Greek GDP in 2010 was €222 billion, while the Irish program of €67.5 billion came of 2011 GDP of €159 billion and Portugal's €78 billion program related to 2011 GDP of €171 billion.
2. For the UK Treasury, I do spare a thought, as the sense of Ice-Save déjà vu must be tangible here, as British troops and government workers in Cyprus will also be affected. Seemingly the UK government will compensate these groups, but not the British expat community in general. See http://www.bbc.co.uk/news/uk-21820237.
3. Note that the breakdown of foreign vs. domestic deposits might be different for small and large depositors, even as it is generally assumed that foreigners account for a bigger share of the largest deposits.
4. These operations are intended to be sold to other private entities operating in the Greek banking sector without any financial burden on the Greek government.