Cyprus: Crossing the ‘Depositor’ Rubicon

Category: Banking sector | Economy | Eurozone
March 19, 2013 | Comments Off |
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Cyprus: Crossing the ‘Depositor’ Rubicon

Cyprus: Crossing the ‘Depositor’ Rubicon

The announcement by Cyprus that it intends to apply a ‘haircut’ to domestic bank depositors has driven credit spreads wider and spooked the markets. Despite a population of fewer than 1 million and an economy equal to 0.2% of the Eurozone’s GDP, the decision has caused major gyrations in financial markets today and may change the face of banking across Europe.

Since 2007, bailouts to save banks and governments have become relatively commonplace. They have occurred in Ireland, Iceland, the United States, Portugal and Greece, just to name a few. And the playbook has generally followed a recognizable pattern: Using customer deposits, a financial institution over-levers itself and buys assets of dubious quality. At some point, the institution runs into trouble as the assets that have been purchased drop in value, become illiquid or simply become too enormous to support. In order to minimize the impact the bank’s failure has on the global financial system, a bailout package is arranged with the prevailing government (s) ‘‘saving’ the institution from ruin. In all cases, the government then guarantees the bank’s deposits and/or other securities to facilitate stability. There are no bank runs – no panic to put cash under a mattress, and life goes on. However, the news out of Cyprus this weekend altered this playbook significantly.

As you may have read by now, the banking system of Cyprus has imploded. The Eurozone finance ministers and the International Monetary Fund have agreed to a €10bn (£8.7bn) bailout for Cyprus. It is the fifth Eurozone member to be saved from bankruptcy, and wouldn’t be that noteworthy if it were not for the way the bailout is being carried out. Domestic bank depositors in Cyprus are contributing to the bailout whether they like it or not – they have no choice in the matter. The Cypriot banks will receive a capital infusion (bail-out), but the depositors have to take a haircut – losing between 7%-10% of the value of their individual bank accounts. The official term for this appropriation of deposits is a “special bank levy”, which will consist of a 6.75% haircut on accounts up to €100,000 (the limit for deposit insurance) and about 10% on accounts above that limit. The pain inflicted on depositors appear to have been necessary in order to get political support for the deal amongst the EU Finance ministers – and political support in the EU was necessary because Cypriot banks hold assets worth somewhere in the neighborhood of 8 times the GDP of Cyprus. The loss or write-down of those assets would endanger the entire EU financial system.

Cypriots have woken up this morning to find bank branches closed for an annual national holiday – which is now rumoured to be extended until Thursday. By the time they regain access to their accounts, it will be too late, as the special levy will have already been withdrawn. While it may be too late for Cypriots to withdraw their cash to avoid the ‘haircut’, it isn’t for other Euro-depositors. And why would any rational depositor leave funds in a Spanish or Italian bank after this news? According to Bloomberg, there are more than €2 trillion in funds on deposit between their respective banks, combined. If even a small percentage of these deposits tried to find a new home, it could push the Eurozone into a full blown banking crisis – yet again.

The Cypriot parliament has just a few days to ratify the bailout, and it isn’t certain yet that it will. Last minute negotiations have been altering the terms only slightly (perhaps as little as 3% for the smallest depositors). However, each iteration still involves all depositors contributing to the bailout of the banks. If the expropriation of Cyprus bank deposits does indeed take place, however, it will mark a new turn in the Eurozone’s on-going financial crisis.

Just as there was no turning back for Julius Caesar’s army’s after crossing the river Rubicon, if the European Union breaks its promise on deposit insurance, it too will pass a point of no return for depositors. In this case, future promises of a ‘government guarantee’ won’t be worth the paper they are printed on.

Courtesy: David Franklin

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