The Cyprus 'bail-in' blunder: a template for Europe?

The justification for the ‘rescue’ plan for Cyprus appears reasonable: taxpayers should not have to pay for the costly mistakes of bankers and ‘tax havens’ should be eliminated. But the ‘bail-in’ plan does not achieve these objectives.

Part One: The ‘bail-in’ blunder.

The German finance minister, Wolfgang Schaeuble, commenting on the defiant rejection by the Parliament of the Republic of Cyprus of the controversial euro-group plan of imposing a ‘haircut’ on all bank deposits in Cyprus, insisted that the citizens of Cyprus and their government needed to ‘understand’ the simple fact that their ‘business model’ was wrong: the island economy’s banking sector was too big. Once the ‘delusional’ Cypriots and their elected representatives understood and accepted this reality they would presumably regret their vociferous objections to the modified euro-group ‘rescue’ plan and accept it as the best way forward for their country.

In its modified version the plan excluded a ‘haircut’ or ‘a one-off levy’ on deposits below 100,000 euros, but involved the resolution of Laiki - the country’s second biggest bank, and a massive ‘haircut’ on the deposits over 100,000 of the country’s biggest bank, the Bank of Cyprus. If Wolfgang Schaeuble is correct in his claim that Cyprus, and by implication other economies with oversize banking sectors, was pursuing an unsustainable economic model his comments, although somewhat arrogant and patronising, could be considered as sound advice. However, even if his chilling diagnosis was correct, which may not be the case, was the prescribed medicine of a ‘bail-in’ the appropriate solution to the problem? 

Before addressing this question it would be helpful to consider some background information about the ‘Cyprus story’ as reported by the global media. It goes something like this. The major problem with the economy of Cyprus was its banking sector which had two undesirable features: first, it was too big in relation to the total economy (seven to eight times its annual GDP); second, as an off-shore financial and business centre Cypriot banks, especially the ‘big two’, Bank of Cyprus and Laiki Bank, attracted huge foreign deposits mainly by Russian depositors (allegedly of dubious origin). The first feature was undesirable because it posed a ‘systemic risk’ for the entire economy in the event that one or more banks failed.  The second feature posed a different kind of threat: it exposed Cyprus to the suspicion, and ultimately accusations by politicians in Germany, that the country had become a ‘money-laundering’ centre within the European Union.

These two features, especially the second one, were to come back to haunt the Cyprus government. In the summer of 2012, realising that both of its major banks were in trouble, Cyprus applied for financial help from its partners in the eurozone. The banks were in trouble because of huge losses from, on the one hand, the exposure of their Greek branches to the depressed macroeconomic conditions in Greece, and on the other hand the ‘haircut’ of the Greek sovereign debt, of which Cypriot banks acquired huge amounts post-2010 from the second hand market. This mixture of bad (or even possibly criminal) decision-making by Cypriot bankers and bad luck created the need, as in Ireland, Greece and more recently in Spain, for bank re-capitalisations. 

Although the request for a loan was made primarily in order to deal with the re-capitalisation needs of the country’s two ailing banks, part of the loan was also needed to fill related gaps in public finances.  The request by Cyprus for a bail-out had certain unique features. First, Cyprus, a tiny economy of 0.2% of euro area GDP, was requesting only 17.5 billion euros which, by contrast to the previous bail-outs of Greece, Ireland, Portugal and Spain, was a comparatively trivial sum in absolute terms although quite large, nearly 100%, when expressed as percentage of Cyprus GDP. Second, elections were looming in both Cyprus and Germany during 2013.

During the initial negotiations between the ‘Troika’ and the outgoing government of Cyprus,  there were some political noises coming out of Germany with regard to the Cyprus bail-out, effectively claiming that the German electorate was fed up having to hand over money to the Southern European periphery. Apart from corruption, deception, laziness, imprudence and inefficiency two new reasons were added to the long list of reasons why the heavily indebted southern periphery of Europe was morally ‘undeserving’ of financial help: reckless ‘gambling’ and money-laundering. Why should, it was asked, the hard working and prudent, mostly German, tax payers rescue an overblown banking sector in Cyprus, which was acting as a ‘Tax Haven’ for wealthy non-Europeans? Is it not fair that part of the burden of rescuing the ‘lop sided’ economy of Cyprus be borne partly by depositors in the banking system which included a number of dubious Russian ‘Oligarchs’? 

Moreover, according to this viewpoint, this plan is not only fair but also efficient for at least two reasons. First it will have the effect of reducing the unsustainably large banking and financial services sector of Cyprus which will bring long term benefits to the economy of Cyprus.  Second, if the experiment in Cyprus is successful (it was clearly too risky to conduct this experiment in a large economy like Spain) it will introduce some market discipline in banking.  By sending the message to all depositors in all banks that if a bank needs re-capitalisation they may be asked to bear some of the cost, they will be forced to take more care where they ‘park’ their savings. The solution therefore was to provide Cyprus not with a ‘bail-out’ but with a ‘bail-in’.

Is there anything wrong with this solution which at the same time protects taxpayers from the reckless actions of bankers and delivers a blow to an offshore financial and ‘tax haven’ centre like Cyprus favoured by ‘Russian Oligarchs’?

If only things were that simple, not only Mr Schaeuble but also ordinary citizens and politicians in Cyprus and hopefully everywhere, would understand and accept the logic of this plan. Unfortunately the world is a much more complicated place, especially the world of money and finance. I suspect most students of introductory economics would remember the excitement they felt when they finally grasped the concepts of ‘fractional reserve banking’ and the ‘bank deposit multiplier’. Of course not everybody understands all the technical details of how banks ‘create’ money, but most depositors have some idea that most of their money in the bank consists of ‘thin air’. Even if they are not aware of this they soon become aware if they see everybody ‘running to the bank’ and long queues being formed outside banks. Of course ‘bank runs’ rarely if ever happen these days and most people are happy to keep their money in the bank even though they have a general idea that their deposits are merely ‘accounting’ entries and not ‘real’ money.

Confidence in the banking system becomes a self-fulfilling prophesy: if people believe their deposits are safe and stay calm then things will be calm which justifies their confidence in the safety of bank deposits. The government plays a crucial role in generating and maintaining confidence. First, this is done through what Walter Bagehot in the 1870s termed the ‘lender-of-last-resort’ function of the Central Bank. All Central Banks provide unlimited but ‘at a price’ liquidity to the banking system thus preventing any loss of confidence to otherwise solvent banks. Second, the government through various ‘deposit guarantee’ schemes re-enforces public confidence in the banking system by reassuring the public that a very large part of their savings is safe even in the unlikely event of a bank failure. 

This was the hard lesson learned from the experience of the 1930s, especially in the US. Between December 1930 and March 1933 the US banking system shrank by half with banks either closing down or merging with other banks. The large number of bank failures during this period was making a bad situation worse, further aggravating the Great Depression in America and the rest of the world.  It is now generally accepted by economic historians (including its current chairman, Ben Bernanke) that the Federal Reserve Board (FRB) bears a huge responsibility for allowing the banking crisis to develop into a full-scale banking collapse: it could and should have prevented the collapse of the US banking system which was part of its mission. It failed to do so because the leadership of the ‘Fed’ adhered to an economic theory that viewed the depression as a mechanism for purging the economic system of the financial excesses created during the boom of the 1920s. Many FRB officials believed that the collapse of the banking system was a harsh but necessary condition in order to ‘cleanse’ the system of its weak components.

Following the collapse of Lehman Brothers in 2008, central bankers and policymakers globally were determined to maintain confidence in the banking system and prevent the disastrous policy mistakes of the 1930s. The taxpayers bore most of the cost of saving the banking system from the threatened meltdown. The disastrous consequences of a repetition of the banking collapse of the 1930s were averted, except of course in Cyprus. After the March 16, 2013 decision of the euro-group to impose a ‘haircut’ on all deposits in Cypriot banks the banking system of Cyprus was effectively destroyed.

There are still a number of un-answered or partially answered questions with regard to the debacle in Cyprus. What was the extent of money-laundering going on in Cyprus and what was its relative significance compared, for example, to the proven money-laundering activity in HSBC and elsewhere? Is the end of Cyprus as a ‘tax haven’, as alleged by German politicians, the beginning of a concerted and determined attack, led hopefully by Mr Schaeuble, on ‘tax havens’ everywhere? Such a progressive policy ought to be applauded by fair minded people everywhere even if the consequences for the people of Cyprus are dire. The whole world will benefit from such a bold and honest attack on tax evasion and tax avoidance. What was the role of geopolitical, as opposed to strictly economic, factors in determining the fate of Cyprus?

All these questions, important though they are, must not detract from the crucial conclusion drawn from this tragic episode, a conclusion that Wolfgang Schaeuble and Jeroen Dijsselbloem (the president of the euro-group) must understand if they do not already know: the ‘bail-in’ proposal is crazy!

Part Two: Why the ‘bail-in’ template is crazy

The objectives of the plan are not at all crazy. On the contrary they are very laudable: tax payers must be protected from the greedy decisions and reckless mistakes of bankers and from the tax evasion and avoidance practices of ‘tax havens’ and ‘money laundering’ centres. However neither in the ‘special case’ of Cyprus nor in Mr Dijsselbloem’s ‘template’ plan for the eurozone as a whole can a ‘bail-in’ plan achieve any of these objectives. Why would it not be possible to confiscate a small proportion of bank deposits to ease the burden of bank re-capitalisation on tax payers?  Why would depositors be so selfish and mean and refuse to help their bank and ultimately the economy of their country by making a small contribution equivalent of just under two years interest on deposits in the case of Cyprus? It is not possible to achieve the admirable objectives of a ‘bail-in’ plan for exactly the same reason that it is not possible to be ‘a little pregnant’!  Having a ‘little’ confidence in a bank or a banking system is like having no confidence.

Depositors will not be able to make a ‘small’ contribution because once the announcement of a ‘haircut’ on deposits is made, effectively the government declaring that it will confiscate some portion of bank deposits, confidence in the bank that the ‘bail-in’ is applied or in the case of Cyprus in the entire banking system, evaporates. Confidence evaporates because uncertainty about what the reaction of other depositors will be, especially large foreign depositors, creates a situation whereby it becomes rational to assume the worst. Kipling’s advice to ‘remain calm when everybody is losing their head’ is rather pointless and futile.

In this situation had banks in Cyprus opened without capital controls, no amount of ECB liquidity provision would have been able to stem the flood of withdrawals out of the banks and out of the country. Sometimes central banks and governments working in tandem and in co-operation they can manage to calm things down and avoid a collapse of the system. In the case of this ingenious ‘template’ for dealing with a banking crisis approved by the European ‘family’ and applied to the third smallest country of the union, the government itself is engineering  the loss of confidence and creating the conditions for a full scale panic. 

Whether Plan A or Plan B or any other plan (such as finding the money from ‘internal’ sources other than bank deposits) was chosen it would not have made any difference. It has been suggested that had the Parliament of the Republic of Cyprus not thrown out the agreed Plan A, the ECB would have been able to rescue the banking system of Cyprus. This of course is a classic counter-factual question the answer to which we will never be able to know conclusively.  I believe, however, that once the proverbial genie was out of the bottle the banking system of Cyprus was gone.

The declared objective of the plan was to spare European taxpayers from having to cough up 5.8 billion euros in order to prop up the oversized banking sector of Cyprus and protect the deposits of ‘Russian Oligarchs’. After the ‘bail-in’ debacle, however, the tax payers both in Cyprus and in Europe may have to spend a lot more to pick up the pieces from the ruins of the Cyprus and possibly other economies if there is a contagion.

Was there an alternative? Yes, it is called ‘bail-out’ and was applied to re-capitalise the banks in Ireland, Greece and Spain - not to mention the UK and US. Madame Lagarde and the IMF were adamant that lending Cyprus the extra 5.8 billion euros would have produced ‘unsustainable’ levels of indebtedness in Cyprus. ‘Unsustainable’? Would the indebtedness have been more ‘unsustainable’ than the current catastrophe inflicted on Cyprus by its European family?

As for teaching a lesson to tax evaders and avoiders globally, or as the Russian Prime Minister, quoting Lenin, puts it ‘stealing from what has already been stolen’, it would be extremely naïve to believe that the destruction of the economy of Cyprus will become a catalyst for the elimination of all off shore ‘tax havens’ and deliver a mortal blow to tax evasion and avoidance globally. The more likely outcome is that capital will flee out of Cyprus to some other oversized banking centre (Latvia being the odds-on favourite) or even possibly London, if ‘Russian Oligarchs’ find the red carpet that Mayor Boris Johnson is rolling out for them attractive enough.

The people of Cyprus have learned several sad lessons since the ‘Black Saturday’ of March 16, 2013. Have Messrs Schaeuble, Dijsselbloem and co learned their lesson? It is a very simple lesson: it is much easier to destroy confidence in the banking system than to maintain confidence. The plan does not work because it is not possible to have ‘a small contribution’ from depositors without destroying confidence; and a sudden and abrupt ‘reduction’ of the size of the banking sector results in its destruction.

All that has been achieved so far by this ‘experiment’ in Cyprus is huge losses by depositors, many of whom are small to medium size businesses, and the destruction, not reduction, of the banking sector. It will result in even bigger losses by all depositors if, as seems likely, Cyprus exits the euro either due to its inability to lift capital controls, or if after lifting them there is a run on deposits in Cypriot banks.

Please Mr Schaeuble and Mr Dijsselbloem throw this ‘template’ in the waste paper basket before you inflict more damage to other fellow citizens, whether they live in big or small states of the European Union. The ‘bail-in’ as an alternative to a ‘bail-out’ has never been attempted anywhere before. As the Cyprus ‘experiment’ is clearly demonstrating it should not have been imposed on Cyprus and it should not be attempted anywhere else. The euro-group policymakers should concentrate their efforts in correcting the various serious ‘design faults’ of monetary union in Europe, such as the absence of a banking union. The ‘bail-in’ template is a nail in the coffin of a banking union, and a setback to any serious effort to reform the single currency in Europe.     

About the author

Yiannis Kitromilides is Visiting Research Fellow at the Centre for International Business and Sustainability, London Metropolitan University. He had previously taught at the University of Greenwich, University of Westminster, University of Middlesex, and at the School of Oriental and African Studies, University of London.