Is the deposit tax in Cyprus a mistake?

The New York Times asked me to write a piece for them on whether the deposit tax in Cyprus was a mistake. Below is what I submitted, though if the final version appears, it may be significantly altered. Enjoy.

The Cypriot banking system is insolvent. Heaping private losses onto taxpayers is bad public policy. Let’s start with those two statements, because starting there makes clear that forcing losses onto bank creditors was the only choice in Cyprus. The question goes to which creditors and using what standards. That’s where the problem lies.

In the past, the European Union has provided funds to help recapitalize severely damaged banking sectors in at least three other countries: Greece, Ireland, and Spain. In each case, the sovereign bore the lion’s share of the burden of bank recapitalization. The end result was immense government debt, an intertwining of sovereign and banking system risk, and the specter of sovereign default, all of which amplified the crisis in Europe and destabilized the euro zone. After multiple rounds of this, bailout fatigue set in. Vocal outcries of “no more bailouts” came pouring from every corner. So Europe had to act.

The question was how to protect the euro yet also prevent bailouts and limit the increase in sovereign debt. So, last year creditors began to take losses – first in Greece, then in Spain. – in what is known in financial circles as ‘private sector involvement’ (PSI). The critical principle of PSI is that when a debtor is insolvent, the insolvency must be recognized as soon as possible and lenders – not taxpayers – must bear the losses associated with it. During the Spanish crisis, PSI became EU policy. And this ‘bail-in’ concept was actively supported both by policy makers and academics in European countries. The goal was to break the sovereign – bank nexus and limit losses to taxpayers.

Yet, as always the Europeans dithered. I expected some bail-in guidelines. They never came. Rather than explicitly set out guidelines for how and when creditors and states will assume banking sector losses, the EU decided to react only when and as necessary. This was a mistake.

The problems in Cyprus have been well known for at least nine months. The country has an outsized banking sector eight times the size of its economy that was heavily damaged by its exposure to Greece. Ironically, it was the PSI in Greece’s restructuring which led to problems in Cyprus. Now, Cyprus’ entire banking system needs to be recapitalized. Where is the money going to come from?

Under the PSI model, some of it will come from loans and guarantees from the European Union and the IMF but some must come from ‘bailing in’ the creditors of Cypriot banks. However, after years of crisis, almost all of the eurozone governments including Germany carry high debt burdens in excess of the Maastricht Treaty, which guides fiscal policy in the euro zone. So, to limit exposure elsewhere, the Cyprus bailout was more heavily geared toward PSI. And because the Cypriot banks have almost no bondholders, the main creditors are the bank depositors. They would have to take the losses. But which creditors should do so?

The right thing to have done would have been to determine exactly which banks were insolvent and only bail in the uninsured depositors of those institutions by swapping enough deposits for equity capital in each bank to reach a safe capitalization level. But, for whatever reason, the Cypriot government didn’t do this. Instead, it is reaching into the pockets of insured depositors as well.  And now everyone is aghast. After all, why have a deposit guarantee if government can expropriate your deposits anyway? It makes no sense whatsoever. Moreover, even though policy makers say this is a one-off, one can’t be sure. What happens in Cyprus could happen anywhere in the euro zone. And so savers everywhere in the euro zone must now decide if their money is safe and for how long.

The Europeans should have set bail-in guidelines and standards for private sector involvement in debt restructurings long ago. And they should have applied them assiduously to recapitalize all the banks throughout the EU, not just in Cyprus. But they didn’t. Instead, they came out of Cyprus with an ill-prepared and ad-hoc solution. And now they are paying the price.

Update: Here is the final version, downsized for space constraints.