This morning we learned that after hours of tense negotiation, Europe has hammered out a 10bn euro “bailout” of Cyprus. I put the term bailout in quotes because the key feature of this deal is the bail-in of Cypriot depositors to the tune of 5.8bn euros, about a third of Cyprus’ GDP. This means that depositors went to sleep on Friday night and woke up Saturday to find that their money, deposited safely in Cypriot banks, had been seized and used to “bail out” the country. While the bail-in became official EU bank rescue policy during the Spanish crisis last summer, bank depositors were never mentioned at that time. I see this as an extreme measure which, if the European banking crisis continues elsewhere, will have very negative implications for bank depositor confidence in other European periphery countries.
The deal terms as reported by Reuters are as follows:
- A 9.9% levy on deposits over 100,000 euros and the 6.75% tax on deposits under 100,000 euros.
- The IMF will contribute to a bailout. The size, maturity length, and interest rate have not been determined. And it is not clear yet what, if any, guarantees are associated with this as opposed to loans.
- Russia will re-finance a loan which is ostensibly to the sovereign for 2.5 billion euros. The 5-year loan will be extended to 8 years and the interest rate will drop.
- Telecoms, ports and utilities privatization may be a pre-condition of loans/guarantees.
- The banking sector, now 8 times the size of Cyprus’ GDP, will be downsized. The average banking sector size in the EU is 3.5 times GDP. Outliers in Europe of this type include Ireland and the UK. (see here for a 2009 calculation of outsized individual European institutions and here for the largest banks by assets as of 2010). Iceland was also an outlier in this regard.
The mitigating factor in terms of preventing a loss of confidence in the European banking system is that the bail-in will happen principally via a one-time 9.9% levy on deposits over 100,000 euros. This is a bank holiday measure that means that Cypriot bank account holders with funds over 100,000 euros will have 9.9% of their account holdings deducted from their accounts when banks open on Tuesday. However, importantly, an additional 6.75% levy is going to hit deposits below that 100,000 euro level. As a bank depositor, given a one-day national holiday to decide what to do with your now shrunken savings, what would you do?
Cyprus’ finance minister Michalis Sarris said large deposit withdrawals would be banned. Jörg Asmussen, a German member of the ECB board and a key ally of Angela Merkel, added that the part of the deposit base equivalent to the actual bail-in levies would be frozen immediately so the funds could be used to pay for the “bailout”. The Financial Times has the best immediate write-up on this. The finance minister is quoted this way in that article:
“I am not happy with this outcome in the sense that I wish I was not the minister that had to do this,” Mr Sarris said. “But I feel that the responsible course of action of a minister that takes an oath to protect the general welfare of the people and the stability of the system did not leave us with any [other] options.”
Some of the bailout lenders like the IMF had actually been calling for Cyprus to seize all deposits larger than 100,000 euros. So this falls well short of those demands. Nonetheless, a rubicon has been crossed. Not only are senior bank debt lenders now on the hook before a single penny of European Union loans or guarantees flow to busted eurozone countries, but so are subordinated debt holders and so are even depositors. As an EU citizen, you must now believe that any lending exposure you have to a bank whether as a bond lender or deposit lender can be seized and confiscated by government, no matter how small the exposure. The FT notes that “[e]ven Ireland, whose banking sector was about as large relative to its economy as Cyprus’ when it was forced into a bailout in 2010, never considered such a measure.”
Bailout fatigue is the driving force behind the Cyprus bank deposit bail-in. The logic here is the same logic that was at work in the confiscation of subordinated debt holders’ money in the Dutch bank SNS Reaal’s bankruptcy. The principle is that the direct lenders of banks will now become the main parties to lose money in any future EU bailout deal. Significantly, sovereign balance sheets will not take a hit unless nationalized banks’ direct lenders do first. No loans and no guarantees will flow before appropriate haircuts are given to the direct bank lenders. And we can see now that this includes depositors. This approach was first adopted as principle during the Spanish crisis last year. European policy makers see bail-ins as critical in breaking the sovereign-bank nexus which has been so destructive during the European crisis.
My suggestion is that preferreds be converted first, wiped out if the capital is insufficient before moving to the debt holders. The debt holders should have an option of writedowns or equity conversion especially because some debt holders from funds are specifically limited in the types of investments they can hold. And senior debt is the stickiest wicket because haircuts here could create contagion. Nevertheless, the outline here is clear: set specific guidelines on how much bailing in one can anticipate will need to occur and this will go a long way toward relieving market funding worries for euro banks.
To the degree that Europe devises a bank resolution scheme along these lines, they will need to use it because bank recapitalisation will be an issue outside of Spain as well.
I hadn’t even considered bank depositor bail-ins. But apparently that’s what was meant as there are few senior and sub bank debt funds to get in Cyprus. To keep the bail-in principle, the EU was forced to bail in depositors then. This is problematic because no clear standardized EU-wide framework was worked out regarding how and when debt holders would be bailed-in as I suggested last July. Moreover, bailing in depositors brings up the spectre of bank runs again. In Spain, angry depositors were aghast when the money they were coaxed into switching out of deposits into preferreds was bailed in when Spanish banks were nationalized. Can you imagine the reaction if depositors actually lost money?
Details are still sketchy. However, if there is a debt for equity conversion instead of just a clear-cut confiscation of funds, that would certainly mitigate the downside. I will have more to say at a later date but this doesn’t look good to me. It’s another ad-hoc solution that will lead to panic and talk of contagion, bank runs and a eurozone breakup. The EU can get away with this in Cyprus because the country is tiny. Would the same approach work in Spain?
What is clear now, however, is that this draconian solution – with even depositors bailed in – was driven by core European countries’ need to tell their own taxpayers that they would not be paying for the mistakes of others, that no German money would flow to bail out the so-called profligate periphery in a German election year. And that’s what matters most as far as EU policy goes.
If you are an investor, clearly relative value-wise, sovereign debt versus bank debt or sovereign CDS versus bank CDS is going to be a good play.
Editor’s note: Reuters mentions that half of Cypriot savers are thought to be non-resident Russians. So this policy will definitely get a response from Russia (though it is alleged that many of these deposits are tax dodges and that the Russian state would be pleased with the policy response as it would shift deposits back to Russia).
Update: Apparently, a condition of the bailout is that Cyprus raise its tax rate from 10% to 12.5%, the same (low) level as in Ireland. This pre-condition changes the tenor of the bailout somewhat as it makes clear that Cyprus is being forced into a corner and forced to alter macro policies in order to prevent its banking system from collapsing. Every European peripheral nation needs to understand that is what loss of currency sovereignty and inclusion in the euro zone means.
Update 2: The IMF now supports capital controls. This shift in policy occurred in December. I believe the shift will matter if the Cyprus bank bail-in scheme destabilizes deposit bases in periphery countries. See here for the wording of the Cyprus bank deposit guarantee. It is not clear what protection this provides and what the implications are for other deposit guarantees in the EU.
Update 3: Reuters now has put together an outline of the bail-in deal. It does include debt-for-equity swaps for the confiscated deposit money. Read the full account here. What is still unclear is whether depositors over 100,000 euros get hit by both the 6.75% tax and the 9.9% levy and whether both taxes get the debt-for-equity exchange. If I find out, I will update here accordingly.
Update 4: Here is a credible narrative of the politics surrounding the Russian bank deposits. I cannot speak to this angle on the story because I don’t know the details. However, the Russian connection to Cyprus is large and it is a major reason that the banking sector in Cyprus is so large relative to the size of GDP.
Update 5: Also see two other posts on this one. Tyler Cowen asks some troubling questions about the large impact of this deal on the EU and the euro zone. And Ed Conway raises some good issues as well regarding the optics of this kind of deposit confiscation.
Update 6: A friend told me that rumours have now circulated that this story about an imminent deposit tax had already leaked to some hedge funds. The question is, “when would this leak have occurred?” The money making opportunity is in Cyprus’ sovereign debt and we should look to trades there and in the CDS as well as in bank debt and bank CDS for an understanding as to whether there in fact were leaks.