The EU Provision which will allow capital controls in Cyprus is Article 65(b)

As I indicated three months ago, the IMF now supports capital controls in specific and extraordinary circumstances, particularly in view of its experience in Iceland. The pre-condition is that the controls be “targeted, transparent, and generally temporary”. This is now relevant given the situation in Cyprus. Matina Stevis and Michalis Persianis of Dow Jones have learned that EU and ECB officials are now working on a contingency plan for Cyprus which includes capital controls. Likely, they would go into place as soon as Cypriot banks re-open for business.

Here is what Dow Jones has to say about the controls specifically – note the part about a “bad bank”:

After Tuesday’s no vote, the ECB issued a statement reaffirming its commitment to provide liquidity to banks “as needed within the existing rules.” The statement implied that banks would get the help if Cyprus’s parliament agrees to the rescue package, analysts said. But if the deal was rejected, the banks would be insolvent and the ECB would withdraw its support.

The contingency measures, described by three European officials, may not need to be implemented if the deposit outflow looks containable. But the plan includes imposing limits on daily withdrawals from bank accounts; capping the amount of money that can be electronically taken out of the country and making these transactions slower to clear; and introducing border checks to cap the amount of cash leaving in the country.

One official also said the IMF had been tasked with developing a plan to merge the country’s two biggest banks—Laiki Bank and Bank of Cyprus—putting their healthy assets into a smaller entity and the nonperforming assets into a “bad bank,” which wouldn’t do any new business.

A spokeswoman for the IMF had no immediate comment. European officials have repeated that the goal is to shrink the island’s banking sector over time.

After the Saturday morning meeting where finance ministers presented the bank-deposit tax plan, Jörg Asmussen, the German member of the ECB’s executive board, said the Cypriot central bank and treasury have “prepared a contingency action plan, they are monitoring deposit flows, even on an intra-daily basis and will take the necessary actions if appropriate.”

The officials said neighboring countries had been instructed to be on the ready to fly euro bank notes into Cyprus should the need arise, but one official said this hadn’t yet happened.

Over the past two hours, I had wondered about this given what we learned about the situation in Cyprus. According to a very detailed account of the situation by Peter Spiegel of the Financial Times, the second-largest bank in Cyprus, Cyprus Popular Bank, which is known domestically as Laiki Bank, has been in contravention of the ELA guidelines for assistance from national central banks because of its poor capital situation. Apparently, the bank has continued to receive ELA assistance from the Cypriot central bank nonetheless. However, a big part of why the negotiations in Brussels were so tense leading up to the deposit levy proposal is that the ECB was threatening to stop this ELA program.

The FT put the negotiations this way:

A counter-proposal was put on the table by Dijsselbloem that would have seen the rate on smaller deposits hit 7.5 per cent, while those over €100,000 would face a 12.5 per cent cut.

While Michalis Sarris, the Cypriot finance minister, was open to the counter-proposal, Anastasiades was not. He got up to leave the room, and was only convinced to stay by Asmussen, who quietly informed him that if a deal wasn’t reached, the ECB would be forced to cut funding to Cyprus’ second-largest bank, Laiki, which was in such bad shape it no longer qualified for emergency loans from the eurosystem to keep it afloat. That would have probably led to the collapse of the island’s largest bank, setting off a complete financial sector meltdown and wiping out all deposits.

The Bank of Cyprus, Laiki and the Cooperative institutions dominate the banking system in Cyprus as they have 67% share of the Cypriot banking. Below is a picture of the system circa 2010.

So clearly if Laiki and Bank of Cyprus went down the whole system would have collapsed. So the threat was that the entire Cypriot financial system would have failed. And this is why the Cypriot government felt forced to take the deposit levy structure back home for a vote, one that ended disastrously.

After one and all learned that the ECB’s Jörg Asmussen believed Laiki Bank could not meet ELA guidelines, it meant that Laiki Bank could never open for business unless there was a successful bailout vote which recapitalized the institution. Otherwise there would be a bank run. There could still be a bank run even if Laiki is recapped. That made it clear to me that capital controls were going to happen. The question was what justification would be used. Karl Whelan of University College Dublin noted by Twitter tonight that the exemption is contained in “The Treaty on The Functioning of the European Union“. He pointed to Article 65(b) in which “The provisions of Article 63 shall be without prejudice to the right of Member States“:

to take all requisite measures to prevent infringements of national law and regulations, in particular in the field of taxation and the prudential supervision of financial institutions, or to lay down procedures for the declaration of capital movements for purposes of administrative or statistical information, or to take measures which are justified on grounds of public policy or public security.

Once these controls are in place they will be hard to take away, as we have seen in Iceland. More shortly for subscribers after the jump.

Note that Greek website ekathimerini reported that Greece is prepared to absorb Greek branches of Cypriot bank to help stabilize the situation concerning any depositor anxiety in that country. This is ironic given the fragility of the Greek financial system.

My view here is that it should have been clear from the outset that going after insured deposits would undermine the deposit insurance scheme not just in Cyprus but throughout the EU. And this deposit insurance is a critical part of the trust that savers have in the banking system in Europe. As soon as you sow the seeds of doubt about the safety of deposits, no matter how small, you make bank runs and systemic financial collapse a real possibility.

Though it does play a role in money transfers in Russia’s banking system, Cyprus is a tiny country and insignificant economically as a result. But it is a member state in the European Union and the Euro Zone. So what happens in Cyprus sets a precedent as to what could occur elsewhere in the EU and in the euro zone in exigent circumstances. The fact that Cyprus is in the EU makes what happen there important. And we have set one dangerous precedent here already – taxing insured deposits – and are set to set another one – erecting capital controls within the eurozone. Trust in the EU, in euro zone, in the European banking system and in fellow European countries is being eroded step by step.  Next thing you know people will be looking at euro note serial numbers and rejecting bills with the wrong letter prefix.  It’s only a matter of time before this whole European project falls apart with distrust building this way. Europe needs to get this sorted fast.

However, what happens next is anyone’s guess. i have already seen two separate reports – one from the French Nouvel Observateur and one from the Dutch Financiëele Dagblad – which say that the Eurogroup is not budging on its negotiating stance. Either Cyprus must find other ways to raise the demanded 5.8bn euros or the Eurogroup will have to alter its stance – and that likely means greater losses for the sovereign, making a sovereign default also that much more likely.