Having stressed publicly that Greece was an exception and that no other rescue would impose losses on senior private creditors, European officials embarked this weekend on a controversial path for Cyprus. They did so for understandable reasons, which they will argue are unique. Yet the specifics of the rescue will bring implementation challenges that will undermine its effectiveness and may lead to negative side-effects.
Early Saturday morning, European officials stunned Cypriots by announcing that part of the burden of rescuing the country would be borne by bank depositors. When banks reopen on Tuesday, all account holders will have their savings reduced by 6.75 per cent to 9.9 per cent, depending on the size of their deposits. In exchange, they will receive an out-of-the-money equity claim on banks.
This constitutes a notable expansion in the EU’s application of PSI (private sector involvement).
In addition to committing €10bn of bilateral and multilateral assistance to support a new austerity package, officials went beyond the Greek precedent of restructuring government bonds (and in isolated cases wiping out junior and subordinated bank bond holders) and extended burden-sharing further.
I can think of at least four reasons that led influential European countries to impose on Cyprus what they previously deemed as improbable if not unthinkable.
The scale of the problem and its concentration in the banking system: Like Ireland a few years ago, Cyprus has been brought to its knees by irresponsible banking. In entrusting funds to Cypriot institutions, depositors (and especially foreign depositors) inadvertently funded the over-extension of the banking system, both domestically and abroad. Now they are being forced to contribute to the bail out.
Lax banking regulation: At a time of renewed emphasis on sound banking worldwide, officials have questioned publicly whether Cypriot banks have intermediate funds with dubious origins. By killing once and for all the notion that Cyprus is a safe and lax offshore haven, the levy serves to limit such intermediation in future.
The alternatives seemed worse: As explained in a frank statement by the Cypriot government, the country had run out of easy options. Impossibly tough choices had to be made among local constituents, including pensioners, wage earners, companies and, of course, depositors.
Countering moral hazard: European hardliners have been increasingly worried about the complacency that has spread in struggling countries following the dramatic involvement of a “whatever it takes” European Central Bank. This weekend’s decision serves as a wakeup call to other struggling European economies, which wrongly believe that the solution to their problems has been outsourced to the ECB.
These are all valid reasons. As such, I am puzzled less by the decision to extend PSI to depositors and more by how it has been done. Specifically:
By choosing to include all deposits and not just the large ones, thus penalizing all segments of the population, officials opted for a highly regressive approach that also undermines the traditional construct of deposit insurance schemes around the world.
By limiting the levy on large accounts to just 9.9 per cent, officials will raise insufficient funds for Cyprus while encouraging remaining deposits to flee the country, thus increasing the likelihood of a second PSI down the road.
If this is correct, the specifics of this weekend’s agreement risk becoming part of the problem rather than a solution for Cyprus.
In Cyprus, they would fuel a private liquidity implosion and more acute credit rationing. They would also risk triggering a disruptive political backlash and social unrest.
In Europe, they could well undermine the recent tranquil behavior of depositors and creditors in other vulnerable European economies – in particular Greece, Italy, Portugal and Spain. Despite assurances from European officials that Cyprus is “exceptional” and the measures are “unique,” this weekend’s actions have increased the risk premium. They will also add to the disillusionment of an increasing of Europeans with the traditional political order and parties.
More generally, the actions will test the faith that global investors place in central banks’ ability to offset political surprises and, thus, enable and protect an endogenous process of economic and financial healing. Since this comes at a time when many risk markets’ assets appear technically over-bought, they could also prompt pullbacks in asset prices.
European officials were right to look for a bold approach for Cyprus. But in compromising excessively on critical design elements, they risk ending up in the disruptive muddled middle: not going far enough to solve the country’s problems, and not being sufficiently careful in containing potential negative externalities.