The new Cyprus deal: victory of common sense

The new deal on Cyprus does not only have the right intentions, but averts the two major flaws of the previous deal:

• It fully protects insured deposits up to the €100,000 amount guaranteed by deposit insurance in all banks, and
• It bails-in all bondholders and shareholders.

The deal has other remarkable elements as well:

• Marfin Laiki Popular Bank (the second biggest bank accounting for about one-third of banking assets in Cyprus), the most troubled bank, will be closed down immediately with full contribution of shareholders, bondholders and uninsured depositors. Insured depositors and the €9bn emergency liquidity assistance (ELA; which allows the central bank of the country to provide loans to banks that do not have collateral eligible at the ECB) will be transferred to the Bank of Cyprus, presumably along with sufficient performing assets (note: Bank of Cyprus is not the central bank, but the biggest commercial bank accounting for slightly more than one-third of banking assets in Cyprus).
• There will be no capital controls: even though the main text of the Eurogroup statement is unclear on “administrative measures” which should be “temporary, proportionate and non-discriminatory” and “to allow for a swift reopening of banks”. But the Annex of the statement specified that only uninsured depositors of the Bank of Cyprus will be frozen until the recapitalisation of this bank is completed. The recapitalisation of this bank will be done by writing off equity shares and bonds and converting uninsured deposits into equity.
• The new bank resolution framework will be used to resolve these banks and presumably other troubled banks as well.

The deal is victory of common sense. Taxpayers should not foot the bill for private-sector losses. Depositors have taken the risk of investing in Cypriot banks and thereby benefited enormously from years of low Cypriot taxes and high deposit rates. They could have taken their money to eg Germany, facing much higher tax rates and much lower deposit rates – but in exchange for more safety. Also, without a bailing-in of depositors, a publicly funded bank rescue in Cyprus would have seriously endangered fiscal sustainability, as I argued in a number of posts last week.

It was also a sensible decision of not introducing capital controls (even though we need to see the temporariness of the unspecified administrative measures). As Guntram Wolff argued, an eventual introduction of capital controls in effect would have introduced a different currency in Cyprus, with adverse consequences. Also, the example of Iceland shows that it is rather difficult to remove capital controls: in Iceland capital controls were introduced in late 2008 with the intention of keeping them in place only for a few months, but they are still in place. [Disclosure: since late last year, I am a member of a working group on the removal of Icelandic capital controls and therefore I cannot comment the specifics of Iceland.]

It was also wise resolving banks one-by-one and not distributing the burden of the losses of some banks to all other banks. For example, in 2011 (the latest bank-specific data I have) two of the seven largest Cypriot banks had a profit, and the return on assets of three other banks was about minus one percent, in contrast to the minus 12 percent return on assets of Laiki Bank. Investors of the better performing banks should not be charged with the losses of Laiki.

And also, it was wise from the Cypriot parliament to pass a bank resolution bill some days earlier, a legislation for which I called for, drawing lessons from Denmark.

Therefore, this time I share the assessment of euro-area policymakers that they have chosen the least disruptive options among the available hard choices.

But the Cyprus crisis is not yet over and there are a large number of issues to worry about.

• Cyprus has to sign the memorandum of understanding for the financial assistance programme, including all details of the restructuring of the financial system, fiscal measures and structural reforms. The programme has to be adopted by euro-area partners as well. And quite importantly, the programme has to be implemented.
• The banks need to open at a day and there is a major risk of a massive bank-run. Such a situation can be manageable with the ELA support of the ECB, which was indicated in the Eurogroup statement. If a large fraction of deposits leaves permanently, the banks should not collapse but they need to sell their assets in order to be able to pay back ELA. Such a process would lead to sizeable reduction of the size of the Cypriot banking system.
• A related major risk is that the “temporary administrative measures”, which I suppose would aim to dampen deposit withdrawals, may prove to be permanent, making it uncertain when and how the Cypriot financial system will normalise, even if bank restructuring will go ahead as planned.
• The growth outlook will be likely revised downward significantly. (See my post yesterday looking at growth and employment in three countries that suffered from massive financial crises). This will raise unemployment, which could make it more difficult for the government to implement the adjustment programme.
• A weaker growth could endanger fiscal sustainability as well. The €10bn euro lending to the Cypriot government, as concluded by the Eurogroup, amounts to about 60 percent of Cypriot GDP. With a public debt ratio of 87 percent at the end of 2012, the rise in the debt ratio will be very significant, even though the two numbers should not be added, because the official loans will likely be distributed over three years and in part will be used to pay back maturing public debt.
• The implications of the deal on other euro-area countries with weaker banks are not yet known. Yet as I argued before (see eg here and here), bailing-in private lenders was the right approach in Cyprus and weak banks in other countries should be strengthened immediately. There is also a strong case for speeding up efforts to complete the European banking union. Also, there is also a strong case for implementing more decisive measures to support economic growth throughout the euro area. Such changes may not come, which would make it difficult to safeguard other euro-area countries with weak banks and gloomy growth outlook.

Overall, while the new Cyprus deal is a victory for common sense, there is very long and possibly winding road till we can be assured that the Cyprus crisis is contained.