25 March 2013

Paul N Goldschmidt: The Cyprus bail in/out: Oh Lord, forgive them for they know not what they do!

The agreement reached has the great merit of avoiding an immediate exit of Cyprus from the eurozone, with all ensuing uncertainties. However, what remains broadly unknown is the extent of the collateral damage, in particular its impact on the implementation of the Banking Union.

The agreement reached during the night of March 24th has the great merit of avoiding an immediate exit of Cyprus from the eurozone with all ensuing uncertainties. It also defines the perimeter of the local funds to be bailed in so as to secure the disbursement of the €10 billion provided by the IMF and EMU Members.

On the other hand, what remains broadly unknown is the extent of the collateral damage that will affect both Cyprus and the governance of the eurozone, in particular its impact on the implementation of the Banking Union.

As far as Cyprus is concerned, one should mention:

1. The resolution of the country’s second largest banks will create significant redundancies in the context of an already weakened economy.
2. The damage wrought by the freezing of bank accounts could further paralyse the economy. This should provoke a cascade of bankruptcies affecting in turn the solvency of local banks which have been spared so far.
3. The risk of massive withdrawals of deposits, hitting all the banks as soon as restrictions are removed. This would necessitate a second rescue operation or, worse, the delayed exit from the eurozone.
4. Significant social unrest, echoing the anger and lack of understanding of citizens, aimed at “Europe” in general and Germany in particular.

If those providing support are right to pinpoint the flaws of the Cypriot banking model (casino economy, money laundering, excessive remuneration of deposits, etc.), one should, nevertheless, recognise that scant consideration has been given to several specific matters, for which responsibility should be shared:

1. The excessive burden born by the Cypriot banking sector resulting from the restructuring of Greek sovereign debt in June 2012. The terms imposed by Europe and the IMF impacted particularly hard Cypriot banks which held a disproportionate amount of these securities due to historic their ties.
2. The situation of Cypriot banks being well known from the outset, it was incumbent on European authorities to compel the Cyprus government, then in power, to negotiate immediately a rescue package rather than to wait for the outcome of the elections. This culpable inaction led to the gradual deterioration of the situation, exacerbated by the initiation of capital outflows.

If the ECB had proposed to allocate be it only a small share of profits realised on its SMP programme, or if the Commission had suggested attributing a part of uncommitted budgetary resources rather than returning them to Member States, then European solidarity would have found a way to express itself without needing to increase the relatively limited burden - in absolute terms - requested from the existing stabilisation mechanisms (IMF and EMS).

Such a gesture would also have contributed to reduce the disastrous effects of the initial proposals agreed during the meeting of the Eurogroup on March 18th. By creating confusion between the proposed levy on accounts of less than €100,000 and the government’s “deposit guarantee” commitment, negotiators, followed like sheep by many economists and journalists, fostered a durable loss of trust of citizens in the banking sector as a whole and in that of the eurozone in particular.

Indeed, the modalities of the rescue accepted by Cyprus can be analysed as follows:

1. The main beneficiaries of the agreement are – in the short term – the EU governments. Indeed, by sanctioning the bailing in of deposits in excess of €100,000 at the bank to be resolved and the one to be restructured, in order to provide for the recapitalisation of the latter, the Cypriot government avoids contributing to the rescue, as demonstrated by the bypassing of parliamentary ratification. It follows that a dangerous precedent has been established with the following implications:
   1. In case of future European bankruptcy or restructuring, it is likely that no recourse will happen to the State guarantee before having bailed in deposits exceeding €100,000; this implies also the wiping out of all equity and all forms of unsecured indebtedness.
   2. If the State (and taxpayers) can rejoice at seeing the likelihood of being called under the guarantee recede, depositors, on the other hand, will be induced to limit any amount held in a single bank account to €100,000 (or even held in the same jurisdiction, fearing that the guarantee might apply to the “beneficial owner” rather than to the “account”). This should translate into a likely flight of capital out of the eurozone.
2. Fragmentation of the eurozone’s money market should, once again, accelerate reinforcing the renationalisation of risks and impacting negatively the liquidity of the interbank market.
3. The financing costs of the banking sector will increase automatically with adverse consequences on the amount and cost of credit available. This will impact significantly the competitivity of the Union whose economy is far more reliant on bank financing than is the United States. 
4. Even before initiating negotiations on the third pillar of the Banking Union, which aims at creating a European Deposit Guarantee Scheme to be largely financed by the banking sector itself, a significant “structural” obstacle, resulting from the Cypriot bail in/out, will now complicate if not prevent the creation of a mechanism providing for the mutualisation of risk on the model of the American FDIC.

In conclusion, on the day following the boasts by the protagonists that they have found a lasting solution to the euro crisis (peace in our time!), the premises of a new crisis are already omnipresent. At best, a short respite has been once again engineered by having recourse to expedients to deal with the immediacy of the crisis. Indeed, whatever assurances may be forthcoming from the authorities, confidence has been thoroughly shaken. Governments will find it difficult to convince citizens that the Union is synonymous with strength!

 

---

Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute

Tel: +32 (02) 6475310 / +33 (04) 94732015 / Mob: +32 (0497) 549259

E-mail: paul.goldschmidt@skynet.be / Web: www.paulngoldschmidt.eu

© Paul Goldschmidt