The banking crisis: Lessons from Cyprus*

©Yannis Behrakis/Reuters

The Cyprus crisis is the result of policy mistakes and a failure of collective responsibility, as well as an illustration of what bad policy can do and could do if it’s not corrected. It’s now too late to take the easier steps that could have avoided the problems we’re facing today, but there are alternatives to the myopic, badly conceived plan proposed by the Troika (the committee led by the European Commission with the European Central Bank and the International Monetary Fund that negotiates loans to the states worst affected by the sovereign debt crisis).

While all deposits are supposed to be guaranteed to 2100,000, those with above that amount were to be taxed 9.9%, and those with less 6.75%; enough to raise about 27 billion, to make up the 217 billion estimated to be needed to rescue Cyprus’ banks (since a limit of 210 billion for Troika bailout loans was imposed). The deposit plan was (naturally) rejected by Cyprus’ parliament.  

The “above-€100,000” depositors are in the main Russian depositors; the bulwark of Cyprus’s role as an offshore centre. 

Large withdrawals of electronic funds have been suspended. Electronic transfer of funds from Cyprus has been stopped. Banks are closed, now until next week.     

Bank collapses would result in some 268 billion deposit insurance liabilities to be paid (at least a third outside the euro area), an amount much larger than Cyprus’s GDP (just under 218 billion)–an unthinkable option.      

While reports suggested there was a Troika threat to cut off ECB liquidity support (hence collapsing the banks), this was not made by the ECB, which has responsibility for such decisions and continues to support the banks for now.       

A key policy mistake in Cyprus was that action was not taken sooner. Hybrid and unsecured bonds should be the first in line (after equity) in burden-sharing during bank failure resolution. Bondholders were involved in burden-sharing in other European countries and implicit bank debt guarantees declined. This caused the amount of outstanding unsecured bonds of Cypriot banks to fall noticeably during 2012 (there is now only 21.2 billion of junior bond holders left!) but the Troika failed to take action to deal with the banks. Consequently, the bulk of liabilities now consists of deposits. Early action would have reduced the cost.        

There is a collective responsibility here. Starting from the failure to act early, one can add more to the list: the losses of Cyprus’ banks derived mainly from holdings of Greek government bonds, which successive European politicians promised would never be allowed to default; the “one size fits all” monetary policy; the failure to implement and monitor the Maastricht fiscal pact; and the permission given to enter the euro in the first place.         

The Troika’s plan amounts to a confiscation of deposits. The most recent example of this kind of policy was Zimbabwe in 2008–confiscating foreign currency bank accounts (puzzlingly the IMF was critical of this then). And there have been examples in extreme crisis situations in Europe and Latin America before that, which also made things worse and left a deep distrust of banking for generations.         

The plan has surprised even the worst critics of the euro project. Not contributing to bank runs is the single most important lesson of hundreds of years of financial policy making in crises, lessons that appear to have been lost on the Troika.       

The full implication of this latest policy announcement from Europe is hard to assess. But policymakers need to rethink this policy quickly.[…]      

Governments went through a lot of trouble to establish new deposit insurance ceilings in Europe. The new harmonised EU (and EFTA)-wide deposit insurance ceilings have to be seen against the background of re-instilling depositor confidence, while also trying to limit moral hazard risks. Major efforts have been undertaken by deposit insurers to raise awareness of these new ceilings. Any policy measure that undermines the credibility of this ceiling runs the risk of triggering a depositor runs in other countries that have banking sectors under stress and weak sovereigns.          

The Basel process is trying to discourage reliance on short-term wholesale funding while favouring retail deposits, with a view to improving the outlook for financial stability. Deposits are currently very much sought after. For example, the relative stability of the Italian banking sector in part reflects the ability of Italian banks to increase their domestic retail deposit base. Haircutting small depositors will undermine these efforts.          

Restrictions on capital flows, should they prove necessary, perpetuate external imbalances, undermine trust, and may prompt and encourage similar measures by other countries.    

There are serious problems on bank balance sheets in certain larger EU economies, which may in the end require bank resolutions. It is only natural that the Cyprus approach be taken as a pointer for what could be done elsewhere: confiscation of deposits. This is very important, because one of the stumbling blocks for the European banking union project is the very nature of deposit insurance and who will pay for it. The precedent being set here will make it more difficult to finalise the banking union project.           

Trust in the financial system is built around the most basic ideas of caveat emptor for sophisticated participants and protections for unsophisticated investors. European politicians have strongly supported the OECD push for better financial literacy and consumer protection–yet the Cyprus plan says that Europe is prepared to hurt the small unsophisticated depositor in banks that they believed were safe.      

Global systemically important banks have not been restructured to separate material derivatives and securities businesses, where caveat emptor should apply, from traditional businesses of deposit taking and lending where protections are important. More volatility can put big banks under pressure via margin and collateral calls, contaminating traditional banking, if the crisis were to escalate from here.[…]         

*This is an extract from an article that first appeared on the OECD Insights blog, 21 March 2013, under the title, “Cyprus: Further compressing the coiled spring”. Read the full text at www.oecdinsights.org. The views expressed in the article are those of the author only, and do not necessarily represent those of the OECD or its member countries. For updates, contact Adrian Blundell-Wignall at the OECD. 

© OECD Observer No 295 Q2 2013




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