It’s simple. Cypriot banks ran out of money.
When this sort of thing happens, the national government will generally stump up the cash but the government didn’t have that sort of money. In which case, the sovereign bank (like the Federal Reserve or the Bank of England) would generate the money, which is an inflationary risk of course but it keeps the wheels turning.
But as Cyprus is a member of the Euro, this could not be. The European Commision, the European Central Bank and the International Monetary Fund, (the Troika) effectively refused to step in. I understand why – the banking debts alone were well over the Cypriot GDP and a number of Eurozone governments would not sanction this, even if direct injection of funds into banks were allowed. The subtext was an anathema towards tax havens in Berlin. Time for a lesson.
Part of the reason for this debacle was the situation in Greece. As Greece tottered towards meltdown, investors in Greek bonds saw their investments marked down 50%. Cypriot banks had invested heavily in Greece for cultural reasons. So not everything was the fault of the tax haven they were building.
The Cypriot government ran out of money to guarantee depositors and nobody would lend it to them. The best they could get was a €10bn loan from the ECB and IMF, contingent on finding further money from austerity – that word again. They were caught between a rock and a hard place and to raise this, proposed a relatively small ‘tax’ on all deposits.
This ran up against understandable opposition from depositors, who would lose 6.75% on deposits up to €100,000 and 9.99% above that. Within the Eurozone, deposits are guaranteed up to €100k by diktat so this could not be, even though the ECB would not back up the mandated guarantee, a very odd position to take indeed.
So the government decided to close the Laiki bank, transferring the first €100k of accounts to the Bank of Cyprus and freezing any remainder. Bank of Cyprus account holders will be similarly treated but that bank is not being closed. Balances over €100k will be part of what it called a bail-in – some part – maybe 60% – will be converted from (liquid) money to (illiquid) shares in the bank. Imagine how much they will be worth. Other parts will be available with or without interest. The total proportions are not entirely clear at the moment. Other banks are not affected.
That’s it. In two words, legitimised theft.
When these things happen it is like dominoes, just as the failure of the Cypriot banks is in part a result of the Greek haircut. Except the further repercussions in this case has cynically fallen entirely on the shoulders of ordinary and innocent Cypriots. This should, I am sure was the calculation, mean that the ‘contagion’ would not spread to other parts of the Eurozone.
Does this matter to ordinary folk? You bet.
If you had money for a rainy day, had transferred it from a pension fund, saved for your children, were buying a house or having to pay staff, suddenly you can’t. Ordinary folk who have jobs may have not get paid. Shops that can’t pay for goods or order more goods will become empty. Cash will be the only currency; Cyprus will become a zombie state.
But there are further implications. Investors will be very wary of a currency which does not have proper banking discipline. Yields – the interest charged by investors particularly to the embattled southern European countries – will rise. Increased yields mean it will become more difficult to recover from the worlds financial mess.
But more. If nothing over €100k is safe in Eurozone banks, depositors will put their money elsewhere. Expect commodities to rise, other currencies too. Some Eurozone banks may become short of money and hence insolvent. So the whole thing will start again.
It is a complete mess and a botched plan.
Whose fault was that?
Three parties really – the Troika, the banks themselves and the Cypriot politicians.
- The Troika was not able to support the banks, nor try. Mario Draghi’s pronouncement last year that he would do anything to support the Euro clearly included impoverishing one of the 17 countries;
- Cypriot financial services that had indulged in tax-haven operations including risky lending particularly to Greece;
- Cypriot politicians who failed to regulate the financial industry properly – not unknown elsewhere – and the recently elected government mandated to stay in the Euro whatever the cost. Taking that negotiating position to Frankfurt was a disaster – the ECB held all the cards.
What should have happened?
- Faced with the obduracy of the Troika, Cyprus should have been prepared to leave the Euro by restoring the Cypriot pound. This would have led to substantial devaluation but, as Iceland has shown (and Iceland’s banks were in a worse position than Cyprus’ banks), recovery is possible if and only if you have sovereign currency control;
- If the political judgement was taken that remaining on the Euro was sacrosanct, all deposits over €100k should have been affected. It is patently unfair that one depositor would lose almost all their money while their neighbour who had the good luck to be with another bank lost nothing.
- Not enough was done to look for assistance from outside the Eurozone. While Moscow was particularly unhelpful, we should remember that the UK retains sovereign military bases on the island – including listening posts essential in the fight against terrorism. Even if Cyprus never approached the UK government, the latter could well have offered, much as it made a £3bn soft loan to Ireland during the latter’s troubles. All this of course may have annoyed the ECB. Good.
Can it happen elsewhere?
Particularly in the Eurozone, yes because of the absence of proper banking regulation and oversight. But it is only likely in a small country far away from the seats of power. Imagine the amount of manure that would be spread around by farmers if a French bank failed and no help was forthcoming!
The reason why Cyprus was dumped on from a great height is that it is far away, there aren’t too many tractors in Cyprus and the small matter of the Mediterranean. Cyprus has been stitched up pour encourager les autres.
Outside the Eurozone, it is highly unlikely. Even when RBS and HBOS almost failed in the UK, (the former being only a few hours away from running out of cash), Northern Rock and Bradford and Bingley were nationalised, no-one lost their money. The government of the day and the Bank of England reacted properly. This has left the UK taxpayer with a huge burden but banks are still working.
There were similar actions taken elsewhere – the US taxpayer’s support of the Bank of America springs to mind, as does the federal takeover of Fannie Mae and Freddie Mac. The raw fact is that the price of a banking failure these days is too much for any government to contemplate so action would be taken by the sovereign currency. This was not done – and because of its design, not strictly possible – for Cyprus.