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Could the EU create a new (and initially 'narrow') bank, leaving 'black’ money deposits to wait for the old banks to be run off completely – thus creating a new frontier for `black’ money?
In the early hours of this morning the Eurogroup reached 'political agreement’ on the 'cornerstones’ of an agreement. So there is much more detail to come, and many questions to be answered. Perhaps the questions can only start to be resolved once the evaluation of the anti-money laundering system in Cyprus is finalised. But Communications Minister Mitsopoulos was blunt about alternatives: “It is the closure of our banks on Tuesday and bankruptcy".
It is hardly possible to get closer to the brink, but the Cyprus `bullet’ is one that the Eurozone could not dodge as Cyprus’ money seemed to be running out. The general perception in `Brussels’ of reckless bank lending (and `black’ money) made it politically impossible to bail out depositors completely. Nonetheless, the euro area Heads of Government have kept their word on avoiding any haircut of government debt – at least for the moment.
As there is widespread official comment that debt ratios above 100% of GDP risk being unsustainable, the Commission’s recent forecast of a 97% ratio in 2014 does not leave much margin for error. The Eurogroup statement refers to consolidation measures of 4.5% of GDP. However, the detailed Programme will be eagerly scrutinised after recent examples of gross underestimates by official forecasters of the depressive effects of such measures.
The decision to tax bank depositors is the new landmark – especially as small depositors are included when an obvious boundary would have been the €100k limit of protection in deposit guarantee schemes. But they are only taxed at 6.7% versus 9.9% for larger depositors. However, the real 'barrel of worms’ is likely to be uncovered in the next five years as the Cypriot banking system is shrunk to the EU average.
If ministers had chosen the eurozone average, the squeeze would have been even worse! EU bank assets are around 3.5 times GDP, whereas euro area bank assets are only about 2.8 times its GDP. What is the size of Cypriot bank assets versus GDP? This should be a simple statistical question but the answer seems to vary between 5 and 8 times GDP. The latter figure includes formal banks, the co-operative banks and branches of foreign banks. Thus the shrinkage may be 30-40% of the system. How can this be done in practice?
However, Eurogroup stated that agreement had been reached about the Greek branches – in a way that “does not burden the Greek debt/GDP ratio”. These branches were reported by the Commission last year to have assets of €24 billion. The IMF (in its October 2012 “Global Financial Stability Report”) estimated Greek non-performing loans at 20.2% of total loans so any buyer will pay a hefty discount for these branches. Who will bear the loss?
At this stage, there seems to be no published commitment to a solution of the `title deed’ problem. The suggested scale seems to vary from 120,000 properties to half that amount. To put this in proportion, official statistics on property transactions record a similar total since 2004! The problem involves purchasers of properties where the title deeds have not been delivered by the developer. Press reports suggest that some developers may have re-hypothecated such titles to obtain further finance. As the banks are shrunk, will a wave of acute problems about enforceability of mortgages be uncovered? These are the difficulties that are likely to surface as the banking system is shrunk by 30-40%.
Could this new tax spread contagion to banking systems in other countries?
The belief that there are huge differences between the quality of bank deposits in Cyprus and other states is so well known that this can easily be seen as a one-off decision. Moreover, the issues of taxing smaller depositors may turn out to hinge on the analysis of the distribution of 'laundered’ deposits that were attempting to benefit from the implicit EU guarantee. In addition, there will be a new withholding tax on 'capital income’. Does that include the profits of Cyprus-based investment companies that are thought to be the counterpart to offshore deposits? The tax paid may bump the Cyprus tax/GDP ratio up from 40% of GDP towards the Greek level of 43% - still well short of the euro area average of 47%.
At the end of the transition process, the citizens of Cyprus should expect that their savings to be held in well-managed banks that provide all the normal banking facilities of payments systems. The safety of their deposits should rest on: (i) the undoubted capital strength of the banks and (ii) good quality assets that also provide proper finance to the growing businesses of Cyprus to foster the economic growth that will restore the island to economic health.
That is a statement of the merits of `motherhood and apple pie’. How can it be turned into practice? The standard procedure in bank resolution is to split out the `bad assets’ leaving a bank with new management to run the `good’ assets – backed by fresh capital resources from …. where?? Is this going to come from the 10% deposit tax that will be reimbursed with shares in the banks? In effect, the depositors will effectively be subscribing – compulsorily - for 10% Tier 1 capital.
In the case of Cyprus, it seems that bank assets include loans to many companies with allegedly dubious origins. How are such assets to be valued in the years to come? The bulk of this transition will be overseen directly by the ECB as the SSM proposal gives it direct authority over banks that are in receipt of bailout funds. Quite when the ECB will be able to operate these powers is another, separate matter and is more likely to be 2015.
• The standard procedure will involve extraordinary legal and moral complexities – in the case of Cyprus. In the end, will it be simpler to reverse the normal resolution process of splitting off the bad assets of banks? Perhaps new banks should be created to run the payments system – the basic purpose of banks – together with assets of proven quality and supported by depositors who are happy to prove their provenance to `Europe’s’ supervisory staff. The deposits that are transferred would carry the right to shares in the `new bank’ as their `deposit tax’ would also be transferred to provide the new capital. Initially, these banks could be run very much as a `narrow bank’ that only invests in a diversified portfolio of euro area government securities. However, the loan book of the old banks would be cherry picked for loans to local citizens and businesses that remain in good standing.
In the likely economic circumstances of the next couple of years, that part of the loan book might be quite modest. But a key part of the recovery programme should be co-financing by the EU – perhaps the EBRD could deploy its skills from emerging economies? The provision of development capital from the EU on a substantial scale is a necessity to demonstrate solidarity with the ordinary people of Cyprus.
• This process would leave behind the dubious assets and corresponding deposits in the `old’ banks. The remaining depositors may find that the Single Resolution Mechanism (SRM) authority applies an aggressive `set-off’ regime between loans and deposits – unless depositors prove their claim. Where tax avoidance is apparent, Cypriot citizens might be permitted to pay a one-off `tax charge’ to bring their deposits back into the island’s white economy. But 'black’ money that does not wish to prove its provenance would have to wait for the old banks to be run off completely, and the final pay-out from the liquidators. Such an approach would constitute a new frontier in the drive against `black’ money.
© Copyright Graham Bishop, 17th March 2013