David Mayes: Cyprus mess a lesson for the world

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Move by eurozone nations to hit ordinary depositors threatens the stability of a fragile banking system.

Cypriots face tough times as the country's economy turns down sharply because of the crisis. Photo / AP
Cypriots face tough times as the country's economy turns down sharply because of the crisis. Photo / AP

At first blush the actions of the euro area in seeking to impose a levy on ordinary Cypriot bank depositors made no sense. They certainly spooked financial markets around the world, and worried depositors in other European countries facing difficulties.

The entire sums involved in putting the Cypriot banking system on a stable footing are of the order of €15 to €25 billion ($23 to $38 billion), which is trivial in the context of the funds available and only 10 per cent of those involved in the case of Greece, itself small by world standards.

Only a small increase in the losses and borrowing costs for all the other countries involved in the assistance programme would outweigh the €5 billion that they hoped to raise from the levy.

The fundamental problem is to find a fair means of allocating the losses in the Cypriot banks. The other euro countries have been unhappy about the banks' behaviour from the outset - mainly in taking large deposits from Russia - and have worried that the Cypriots have not been adequately supervising the banks since.

Unfortunately, the euro countries have not had the power to stop them, although they could have used this as a reason for not admitting Cyprus to the euro area. Ironically, they will have the power once the recently agreed "banking union" comes into force.

Thus under this view, the Russian depositors have benefited, as have the banks' owners and - to an extent - the Cypriot population at large, as the economy has grown faster and deposits have been translated into increased lending. It has been a choice and one made over the past 20 years. Hence those choosing, those responsible, those deliberately taking the risks and those benefiting should pay.

The Cypriot government could have borrowed from other euro area countries and the IMF, or underwrite a direct bank recapitalisation, but this is not credible because Cyprus is too small relative to the size of the problem. Putting all the risk on future Cypriot taxpayers is unfair ... the Irish experience is scarcely encouraging.

There is of course a previous European example of handling banks whose losses dwarf the economy. Iceland chose not to disadvantage domestic depositors and borrowers, although foreign depositors (or rather their insurers) will have to wait a long time to see their money back.

Iceland split its main banks into a recapitalised domestic part and a failed foreign part that has entered insolvency, and gave depositors priority. Thus the rescue was relatively small and could, with difficulty, be afforded by future taxpayers, with losses being borne by shareholders and main creditors (principally foreign bond-holders) who knowingly risked financing Icelandic banks.

The same sort of thing could be done in Cyprus, so why has the euro area waited until the very last minute? One is tempted to paraphrase Churchill's remark that "You can always count on the Americans to do the right thing - after they've tried everything else."

The problem is that some of the losses would fall on already weak European institutions, particularly given the close relationship with Greece. Furthermore, it could impose substantial losses on Russians, even if only temporarily in some cases. Not surprisingly many hoped that the Russian government might meet the shortfall.

Of course that could not simply be a loan either, because it would be unlikely to be repaid. An alternative was pledging future revenues direct, and Gazprom - the Russian hydrocarbon giant - considered offering funds in return for a licence to develop likely oil and gas reserves.

In the end, playing a chicken game wouldn't be a smart move, as Cyprus is not Greece.

The losses to the rest of the euro area in a Cypriot financial collapse are small, even if it involves exit from the euro area. The political costs are higher, especially if it involves closer arrangements with the Russians.

However, the costs of worrying depositors throughout Europe about their deposit insurance of up to €100,000 per account per bank not actually existing are high. Financial stability is fragile and built on trust. It is much easier to lose that trust than rebuild it, and the costs in the meantime can be enormous.

These costs are not just to Europe but they apply here as well. Banks are paying more to borrow. People want to be clear about whether they might lose and, if so, how much.

Ordinary Cypriots are going to lose a lot as their economy turns down sharply as a result of the crisis, but at least they won't lose twice by having their bank deposits reduced so that the better off can lose less.

David Mayes is professor of banking and financial institutions at the University of Auckland Business School.

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