Notes from a small island

The remedies imposed on Cypriot banks by the European Union and the International Monetary Fund are not good precedents for helping banks in difficulty

I recently spent three days in Cyprus talking to political and economic actors, and encountered a very strong sense of determination to overcome their present severe economic difficulties.

Those difficulties arose from mistakes made in the banking sector, which saw very large overseas deposits (mainly from Russia) invested in lending to the Greek private sector and in Greek government bonds. Cypriot banks’ exposure to Greece totalled €28 billion, or 170% of the entire Cypriot gross domestic product. This concentration of risks in one place was bad banking practice, in the same way that excessive concentration of risks in the construction sector was bad banking practice in Ireland and Spain.

As in Ireland and Spain, Cypriot banks also lent unwisely in the domestic economy, fuelling a real- estate bubble. Meanwhile, and partly as a result, the Cypriot economy also lost competitiveness.

The Cypriot Central Bank must accept a major share of the blame for this excessive concentration of risk, having failed to exercise its power to stop the accumulation.

Once Cyprus joined the euro, the European Central Bank (ECB) also had a responsibility. Under article 14.3 of the ECB’s statute, national central banks are obliged to “act in accordance with the guidelines and instructions of the ECB”. And under article 25.1, the ECB may also offer advice on the scope of national legislation for the prudential supervision of credit institutions”. It is open to question whether the ECB used these powers in sufficient time. The ECB policy that banks did not have to set aside reserves against holdings of government bonds artificially incentivised Cypriot banks to invest in Greek (and other) government bonds, and that distortion continues.

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At the end of 2011, the European Union, the International Monetary Fund (IMF) and the ECB found that the public finances of Greece were so bad that senior bondholders (whose position in the Irish case had been famously protected from haircuts by the ECB) would have to suffer a 75% haircut. This created an immediately critical situation for the Cypriot banks, which lost 33% of their capital.

This crisis for the Cypriot banking system was known to the EU/IMF and to the Cypriot government at the time of the Greek haircut. Apart from a temporary loan from Russia, little was done. The Cypriot government of the time did not respond to suggestions that it apply for assistance in a timely way. More could perhaps have been done to require the then Cypriot government to act.

The myth about Russian ‘hot money’

Meanwhile, a press campaign was mounted to suggest that the Russian depositors in the Cypriot banks were tax-evaders, money-launderers, oligarchs or worse.

This campaign seemed to be designed to persuade public opinion that depositors in Cypriot banks were less deserving of protection than depositors in banks in Athens, London or Frankfurt. In fact, little evidence has subsequently emerged to justify any of these stories.

Indeed, there is a perfectly good reason for these Russian deposits in Cypriot banks. Many Russian businesses did not trust their own legal system, and felt that their assets would be better protected in a country such as Cyprus, with a common legal system, inside the eurozone. But in March of this year, they were to be brutally disabused of the notion that eurozone banks were a safe haven.

In March, an agreement was reached between the IMF, the EU and the ECB with the newly elected government in Cyprus, which had had little or no time to assess the options for themselves.

Permanent uncertainty

The March agreement contained a number of elements that are troubling.

For the first time this century, depositors have had to take a haircut. This was a radical departure from previous policy.

The procedure used creates a new and permanent uncertainty for depositors who hold more than €100,000 on deposit in any bank in the eurozone.

To protect their assets above €100,000, they must now regularly scrutinise the situation of their bank, and move money out of those banks that seem to them to be pursuing risky strategies. Some would see this as a market solution to bank supervision, but markets work only if there is full and timely information available to all market participants. Most depositors will not have the requisite information.

For a retail-bank depositor with little financial expertise, getting the relevant information on the safety of banks will be difficult and time-consuming. The accounts of banks are often opaque and do not always tell the full story. There will be a tendency to move money towards bigger banks, so aggravating the ‘too big to fail’ problem.

Under the terms of the March agreement, no haircut was imposed on depositors in the Greek branches of the Cypriot banks, which were transferred to Greek banks. Additional losses were therefore imposed on Cyprus, which is hard to justify in a monetary union that comprises both Greece and Cyprus as equal partners.

Frozen credit

The Cypriot banking model of attracting overseas deposits has been destroyed, although Russians continue to invest and holiday in the island, so disproving the suggestion that they were all fly-by-night tax evaders and hot-money merchants. It would be interesting to know which country’s banks are now benefiting from the Russian deposits that were formerly in the Cypriot banks.

Meanwhile, viable Cypriot businesses that before March were well capitalised and equipped with working capital, are struggling to get access to funds.

Deposits they could have used have been reduced by haircuts, and capital controls mean that what remains in their accounts cannot be used freely. Bank credit is frozen.

An economic model for Cyprus based on exports, to replace the old model founded on attracting bank deposits, cannot be put in place without access to day-to-day funding.

I left Cyprus feeling that, if Cyprus had constituted more than just 0.2% of the eurozone’s gross domestic product, and if it had been physically closer to the centre of Europe, it would not have been subjected to these radical experiments in European banking policy.

It would, instead, have been the subject of much timelier and less harsh responses from its eurozone partners. That said, none of the options was palatable. Asking Cypriot or European taxpayers to recapitalise the Cypriot banks would have not have been easy and might have set a dangerous precedent. But burning depositors is a bad precedent too, when restoring confidence is so important.

Of course, Cyprus must now abide fully by the terms of the March agreement, and, like Ireland, establish a good track record.

If it does so, it should, like Ireland, see progressive easements in the terms of its bail-out, so that its economy can be allowed to breathe again.

Meanwhile, the Cypriot horror story should remind us of the urgency of completing a European banking union, including some form of mutual deposit insurance.

The EU also needs to develop automatic stabilisers to deal with the problem of asymmetric shocks to individual states, as suggested in a recent IMF paper on the euro. Without them, the European economy will continue to run at below capacity, at the very time when it should be building up surpluses to cope with the looming cost of its ageing populations.

John Bruton was prime minister of Ireland in 1994-97, having previously served as the country’s finance minister. He was head of the European Commission’s representation to the United States in 2004-09.