My RealTime posting on March 25 about the potential precedent set by the Cyprus bailout deal provoked much commentary focusing on the impact in the euro banking system. Let me elaborate. The precedent of imposing losses on uninsured depositors in Laiki Bank and the Bank of Cyprus was a sound one, but that does not mean it will be a widely used one in the euro area—or that it puts the entire euro area banking system at risk of depositor runs. Some of the other precedents will do more good than harm.
How Unique Is Cyprus?
Recall, for example, that the Federal Deposit Insurance Corporation (FDIC) guarantee in the United States is not open-ended. Deposits in excess of $250,000 are uninsured and at risk.1 Yet regulation of commercial banks is sound enough to have generally avoided closing down a US bank, imposing losses on the uninsured depositors. (Investment banking regulation is another matter!) Rather, in the overwhelming number of cases, the losses have been felt only by shareholders and junior and senior bondholders of the closed bank. The best known recent example of uninsured depositor losses in the United States is probably the closure of IndyMac Bank in July 2008. It occurred before the increase of the deposit insurance limit from $100,000 to $250,000. Uninsured depositors lost 50 percent of their money.
Will the fate of Laiki Bank and Bank of Cyprus be as rare in Europe as IndyMac Bank was among US banks? How unique is Cyprus?
Pretty unique, actually. For one thing, the Cypriot banking system is hugely outsized, with more unusual characteristics, compared to the national economy than systems in other countries. Figure 1 shows the relative differences in sizes among the EU banking systems as a share of national GDP.
The term for banks is monetary financial institutions, or MFIs, in European Central Bank (ECB) jargon. For Ireland, figure 1 includes the balance sheet of the soon-to-be liquidated Irish Bank Resolution Corporation (IBRC), inflating the Irish MFIs by about 40 percent of GDP. Thus only Luxembourg, Malta, and Ireland are in the same league as Cyprus in terms of the size of their banking systems. Figure 1 also shows how the Cypriot banks, as a share of GDP, had only half the capital reserves of the similarly sized Maltese banks—84 percent for Cyprus vs. 160 percent in Malta. Although Maltese banks are as large as those in Cyprus, they have twice as much equity with which to survive shocks. In addition, the bulk of Maltese (and Luxembourgian) banking assets reside in foreign bank subsidiaries with virtually no exposure to the domestic economy, while the domestic Maltese banks are relatively small (about 300 percent of GDP) with limited international operations and no Cyprus-like reliance on a foreign depositor base.
Figure 1 further illustrates the second abnormality in Cypriot banks, discussed earlier on RealTime. They issued few bonds, worth 10 percent of Cypriot GDP. Instead they relied on deposit financing, necessitating the losses imposed on depositors once their equity was wiped out. Figure 1 does not break down debt securities into secured (collateralized) and unsecured bonds, but it makes clear that most other euro area banking systems have a larger pool of bondholders on whom to potentially impose losses.
What Are the Risks of Moral Hazard from Cyprus?
The Cyprus rescue was undertaken in part by the ECB using its emergency liquidity assistance (ELA) lifeline through the Central Bank of Cyprus to prop up the Cypriot banks. As discussed earlier on RealTime, the ECB's informal rules make such an action acceptable only when channeled through a national central bank and if no financial losses are incurred. As we saw with the bank resolution corporation in Ireland, Cypriots must now accept the ECB and the other European central banks as super-preferred creditors as the price of their stepping in a year ago to provide liquidity to the two troubled Cypriot banks, which were on the verge of collapse after the Greek government debt write-downs. Many large (resident and non-resident) depositors fled from Laiki Bank, forcing it to turn to the ECB for assistance. ELA assistance to the Cypriot banks was zero in March 2012, 21 percent of Cypriot GDP in April, and more than 50 percent by July 2012, a level at which it has stayed until today.
The Greek debt restructuring was a blow to the Cyprus banks, but ultimately Cypriot bankers and the Cypriot Central Bank, their main regulator, must share responsibility for the failure to spot the risks of the nation's reckless banking model. (Anyone doubting the incestuous nature of the banking business in Cyprus might note, for example, that the Cypriot finance minister, Michael Sarris, was chairman of Laiki Bank's board until a few months ago!) The rationale for the system is complicated but not mysterious. In a strategy reminiscent of the infamous IceSave scheme by Icelandic banks in the United Kingdom and the Netherlands, Cyprus's banks offered low tax rates and generous deposit rates—4.5 percent annually vs. maybe 2 to 2.5 percent elsewhere in the euro area—to an increasingly big non-resident depositor base, from Russia especially. As for lack of mystery, the two Greek banks show in their annual reports how their dubious strategies continued until the end. Laiki Bank's 2011 annual report describes the strategy of maximizing returns to depositors as follows:
As far as deposits are concerned…the strategy focused on securing the necessary liquidity, bearing in mind the profitability targets of the Bank…. Retail Banking developed a wide range of deposit products at very competitive terms to satisfy the demands and needs of each customer….
The 2011 annual report of the Bank of Cyprus states on the same issue that the Bank of Cyprus is
focused on deposit growth…. despite the fierce competition for attracting deposits in the Cypriot market and the general negative environment, the well-established relationships of Bank of Cyprus with its retail customers and the latter's confidence in the Bank continued to be reflected in 2011 in the local euro deposits portfolio, which recorded an increase of 6,5% compared to the previous year.
Needless to say, paying depositors that much is costly. To offset those costs, the Cypriot banks had to make equally high yielding loans to the Cypriot domestic economy as well as to high yielding (and high risk) assets. Such assets dried up when interest rates fell across the advanced economies following the global financial crisis. Beyond Cyprus's ties to Greece, it was thus not a coincidence that Cypriot banks remained so heavily invested in high yielding Greek government bonds in 2009–10 just as Greece plunged into crisis. The Cypriot banks had to seek out this kind of high yielding but risky asset to finance their deposit inflows and their increasingly risky business model.
Hopefully a future Cypriot government inquiry into these issues will allocate blame where it is due. Yet fortunately from the euro area perspective, a similar degree of complacency among another euro area nation's bankers and national banking regulators seem unlikely. At least the far higher capital levels in the similarly sized Maltese banking system seen in figure 1 suggest a different and more conservative regulatory approach than seen in Cyprus.
For all these reasons, Laiki and Bank of Cyprus can be seen as the functional equivalent of IndyMac bank, with little worry that its troubles mean that uninsured depositors will suffer financial losses in future bank liquidations/restructuring in the euro area.
Out of the Cyprus Crisis, Opportunity
Faithful readers of RealTime will recognize that this author has rarely seen a euro area crisis as less than a sign of progress of the euro area. There are plenty of opportunities for the euro area to use the Cyprus debacle to move forward.
Hence I argue that forcing losses on (i.e., "bailing in") creditors in the Cyprus bailout, rather than forcing losses on European taxpayers is a welcome step towards breaking the doom-loop between governments and their banks in the region. If implemented rigorously, saddling bank creditors with the bill for a bank failure (while excluding insured depositors) would sever the loop completely, though not in a way many bankers would have chosen or predicted after the initial declaration of the banking union in June 2012. The doom-loop will not be broken by the infusion of outside equity through direct bank recapitalization from the European Stability Mechanism (ESM). Rather it will be broke because of losses borne by uninsured bank creditors.
Sometimes a precedent not established in a crisis is just as important as one that is. In this case, it was significant that the European Stability Mechanism (ESM)—established last year as a principal bailout mechanism in the euro debt crisis along with the ECB and its ELA—did not provide money to recapitalize Cyprus's banks. Had it done so, troubled banks in other countries might have been encouraged to continue their risky behavior, thinking they too would get recapitalized if necessary.
Instead, in this case, the ESM funded the Cypriot government so that it would have to step up to the plate and restructure Cyprus's banks. Eventually, when the ECB takes over the role as banking regulator in the euro area, it will still have to rely largely on national regulators like the Central Bank of Cyprus. The Cyprus case leaves it clearer that because national governments must bear most of the costs of bank failures, national regulators will work diligently to expose weaknesses early. They will not be tempted to cover up problems until the ESM steps in. Moral hazard among regulators will have been reduced.
Fear of investor losses in Cyprus has focused attention on other euro area banking trouble spots. A recent IMF report singles out "severe stress" felt by Slovenian banks, which are hobbled by large numbers of non-performing loans, many of them to politically connected and state-owned firms. The Cyprus deal will now have the effect of encouraging Slovenia to act on this problem, while it can still do so and avoid the need for a tough bailout program (and Cypriot-style treatment of its banks).
Not that the new status quo is without risks, including the unleashing of a bank deposit run in the euro area. Yet, among retail depositors, the generally high threshold for retail depositor contagion between different countries and renewed political commitment to insured depositors below €100,000 suggests that this is not a major risk. This renewed political commitment, however, must soon be backed up by a joint euro area deposit guarantee fund, which Germany and other Northern countries have resisted. Now they will have to accept such a fund in return for their getting Cyprus to restructure or liquidate its banks, and to avoid future direct bank recapitalizations by the ESM.
The EU Commission and Commissioner Michel Barnier should now offer euro area governments a "grand bargain" as part of its upcoming proposals for the new euro area single resolution authority for banks in need of restructuring or liquidation. Such an accord for the remaining two outstanding parts of the banking union would rank creditors for euro area banks in a way similar to the ranking used by the FDIC—first shareholders, then junior bond holders, then senior bondholders and then uninsured depositors. Germany wants the Cypriot "bail-in" of bank creditors to serve as a model for the resolution of future bank crisis. By contrast, France, Italy and Spain want a jointly funded deposit guarantee fund for the euro area. The bargain would call for Germany to go along with a resolution fund that would impose losses on creditors in return for a joint deposit guarantee fund sought by France, Spain and Italy.
As for the large uninsured depositors above €100,000 euros, now exposed by the Cyprus precedent to higher risks, the Cyprus bailout will certainly make them more wary about their exposure to similar losses in the future. Consequently, more competition among banks for this type of large deposits will emerge, an unambiguously good thing.
Despite these developments, the fear of a stampede of bank deposits out of the periphery and into the core euro area countries—in the belief that Germany will bailout its own banks even if it refused to do so in Cyprus—is unfounded. Future German governments will find it difficult not to apply the Cypriot precedent to itself, even in the case of a German bank failing, because of the abiding anti-bank political sentiment in Germany. Yes, it was hypocritical of the Dutch finance minister Jeroen Dijsselbloem to call for bondholder losses in Cyprus after sparing senior bondholders in the nationalized Dutch bank SNS Reaal a few months ago. But political support for protecting bank bondholders has disappeared throughout the euro area. The EU Commission has more incentive than ever to establish a single resolution authority to remove opportunities for regulatory arbitrage among euro area nations, with deposits shifting to banks in countries where the protection against credit risk is highest.
Implementing a Cypriot bank bail-in model for the euro area should therefore lead to increased pressures on the weakest banks. Large depositors may flee weak banks, while stronger banks reap uninsured deposit inflows. Well-managed and capitalized banks should no longer have to worry as much about being dragged down by the economic problems of their sovereign, including in Spain and Italy. The risk of too many weak banks in one troubled country could aggravate that country's credit crunch in the short term, requiring the ECB to consider new non-standard measures to channel credit to them in order to help small and medium enterprise (SME) borrowers. The ECB, for example, could purchase asset backed securities (ABS) made up of SME loans, as it did with two covered bank bond purchase programs in the past. Such help could also be extended by the European Commission or national governments.
The euro area needs to kick-start non-bank intermediated credit to its non-financial sectors, and to establish deeper corporate bond markets, because banks are now less able to do so. Perhaps the European Commission or national governments could offer partial fiscal guarantees to ABS made up of SME loans (a bundle of loans from small and unrated SME borrowers) to induce the ECB to step in. With Frankfurt backing this up, real money investors like pension funds and others should be willing to enter, too, and thus rekindle such a credit market.
Adopting the Cypriot model is not without short-term risks, but they are manageable and should not prevent Europe from taking another step forward. It will require that Germany compromises on a joint deposit insurance fund and perhaps that the ECB dips its toes in the ABS market.
Stranger things have already happened in this crisis.
1. The FDIC insured deposit limit was increased temporarily from $100,000 to $250,000 during the height of the financial crisis on October 3, 2008. This temporary increase was made permanent with the Dodd-Frank financial reforms in July 2010.