By Jerry O’Driscoll


Cyprus is the latest country to succumb to the financial rot in the European Union. Once a banking center, its citizens now cannot pay for their own imports. Exporters are demanding cash only for goods sent to Cypriote businesses. Credit has dried up. Businesses are closing because they have no goods to sell.

The economic crises in the various countries have fallen into two types. In the first type, highly indebted governments experienced fiscal crises and could no longer service their debts. Banks had lent to these governments and their condition was impaired by the value of the government bonds falling.  The economies went into recession, which was aggravated by higher taxes and enhanced collection of taxes. Greece is the poster child for a financial and economic crisis begat by a fiscal crisis.

In some countries, the country’s banks engaged in imprudent lending to private firms – typically property developers and overextended homeowners.  The banks became insolvent as the loans soured. Credit was curtailed and the economy went into recession. Then government revenue fell and a fiscal crisis ensued. A highly indebted private sector and irresponsible banking sector caused a fiscal crisis. Ireland and Spain exemplify this type of crisis.

Countries can experience banking crises without a fiscal crisis and vice-versa. When the two occur simultaneously, recessions tend to be deeper and prolonged. If there is also a currency crisis, the crisis deepens further. The Euro Zone has thus far escaped that.

There is much outrage over how the Cypriote crisis banking crisis was resolved. An example is Frederic Sautet’s recent post at Coordination Problem. Many were shocked that large depositors lost money in the resolution of two insolvent banks. Let us be clear on how and why that occurred.

First, the banks were insolvent. They had engaged in imprudent lending, particularly to the Greek government. They could not pay their creditors. Depositors are creditors. Second, the Cypriote government could not bailout the banks. The banking sector was outsized compared to the rest of the economy (the ratio of bank assets to GDP was 7.5 by one account). Small countries in which the banking sector is very large relative to the rest of the economy are at risk for banking crises. That was an important factor in both Ireland and Spain. (It was also the story in the earlier crisis in Iceland, which is outside the European Union.)

Third, the Cypriote government could not print money to bailout the banks because Cyprus is in the Eurozone.  Therefore, the only alternative was for taxpayers in other countries, notably in Germany, to pay for a bailout of depositors at Cypriote banks. German (and other) taxpayers are tired of bailing out profligate banks and governments of others countries.

The depositors who lost money were uninsured depositors (deposits above €100,000). What do the critics of the resolution think uninsured means? Surely it means your money is at risk. True, in recent banking failures, governments have been reluctant to let even uninsured depositors lose money. But that was policy, not law.

A sudden regime change is always painful. Indications are that future bank bailouts in the EU may follow the Cypriote model. Bank depositors must understand that they are creditors of the bank. If they lend more than the amount insured, their money is at risk like that of other creditors.

The sad fact is that there is not enough money in the Eurozone to pay off all the debts (private and governmental) incurred in the zone. Households, firms, and governments have taken on more obligations than they can pay. Thus far, to its credit, the European Central Bank has been unwilling to engage in wholesale depreciation of the currency. That may come next. Likely, first there will be more bank failures and resolutions as has just happened in Cyprus.

Critics of the Cypriote bailout must explain what the alternative bailout policy might have been. And they must also explain why we should not be outraged at their alternative.

13 thoughts on “Cyprus

  1. I think what most of critics are outraged about is that shareholders will not be wiped out. One would think that depositors, though unsecured, should still be senior to most other liabilities.

  2. As you say, the insolvent Laiki Bank was handled properly: it was closed. The insolvent Bank of Cyprus is a different story. The bank is not being closed. It is instead being given positive net worth by cutting its uninsured liabilities as much as necessary, and giving the unisured depositors shares (worth a fraction) instead. An alternative policy would be to treat it just like the Laiki Bank. Wouldn’t that be less outrageous?

  3. To Mathieu,

    My understanding is the shareholders are being wiped out. See Larry’s comment.

    To Larry,

    In New Zealand, which has no deposit insurance, failed banks can be resolved by giving depositors shares in a recapitalized institution. I see no objection to recapitalizing banks in order to keep them open. That is a market solution if taxpayers funds aren’t used.

  4. Jerry, thanks. Either resolution convention seems okay per se, but I wonder about the non-parallel treatment of the two failed banks, which seems inconsistent with the rule of law.

    Maybe you know the answer to another question that press accounts I’ve seen haven’t answered: What is the intended destination for the €10 bn that the IMF and EU are kicking in? Is it for recapitalizing banks, is it for enabling the Cyprus government to roll over its bonds, or some other purpose?

  5. Lawrence, the EU money goes to the Cypriot government. The sub-100k deposits and any valuable assets of Laiki are being merged with Bank of Cyprus. I guess that’s why it’s being kept alive. BoC shareholders will have to cough up until an equity ratio of 9% is reached.

  6. I think the removal of stockholders’ limited liability would do wonders for the banking industry.

    I bet Jon Corzine would have watched over his customers’ money a lot more closely if he knew his personal net worth was at risk for the $1billion dollars that disappeared under his watch at MF Global.

  7. York, yes, the €10 bn goes to the Cypriot government, but for what purpose? To pay off the insured depositors? Roll over sovereign bonds? Or something else?

    Jerry, so I take it that in the case of the Laiki bank, even erasing the uninsured deposit liabilities completely left the net worth negative, whereas the Bank of Cyprus could attain 9% positive net worth by erasing 60% of the uninsured deposits. In that way the BoC uninsured depositors get less cash (compared to a liquidation), so in a sense they’ve been dragooned into swapping cash for shares. But they can sell their shares if they’d rather have the cash. Better for them if they all don’t try to sell at once.

  8. Jerry, if, in a currency area you allow some governments to backstop their national champions while other countries can’t do it / afford it, the word “competition” for the financial services industry is at best devoid of any meaning. We’re not so far from mercantilism, financial colonization and beggar thy neighbour policies. What about if the same is going to happen for automakers? Remeber that the Single Market can work properly since State aids are banned, or completely coordinated (like for agricolture or farming). Otherwise, if such kind of policies start to be very asymmetrical, the word “Union” makes no sense from a politcal standpoint.

    Cyprus government get 10bn euros in order to pay bay back securities which actually are in ECB portfolio or pledged as collateral, for the benefit of creditors. If a private manager behaves in such way, I don’t know in US, but here would be prosecuted for preferential bankrupt. Credit scoring is up to the lender, but some lenders are more equal than others.

  9. is no country to small for their banks to fail?

    New Zealand had a fee based government guarantees from 2008 for banks and for finance companies.

    the losses were about $2b when one or two finance companies quickly failed. the police are investigating.

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