Cypriot sovereignty surrendered

Fingers Crossed

Here is a rant about events in Cyprus. Normal dispassionate service will resume here at the Mule in the next post.

Over the weekend, the European crisis took a sickening new twist in Cyprus. The government of Cyprus announced a “levy” on Cypriot depositors as part of a deal to secure a bailout of its ailing banks by international lenders. In doing so, it has dramatically demonstrated how completely Cyprus and other eurozone nations have surrendered their sovereignty to the technocrats of the European Commission, the European Central Bank (ECB) and the IMF.

The president of Cyprus Nicos Anastasiades has told his citizens, subject to getting the numbers in parliament, his government is about renege on past promises and appropriate the savings of pensioners to make good the failings of others. This is not the first time that the global financial crisis has claimed innocent victims, but it is perhaps the most striking example of this phenomenon.

Cyprus’s financial woes stem from the fact that their banks had significant investments in Greek government bonds. Back in March 2012, as part of the bailout of Greece, investors in these bonds suffered a “haircut” of 53.5%. Somewhat less euphemistically, holders of these bonds lost more than half of their investment. This left Cyprus’s banks in deep trouble and, while negotiations with Europe for a bailout continued, the ECB kept them afloat with emergency funding. The threat of suspending that ECB support was the gun to Anastasiades’s head that led him to agree to the disgraceful bailout scheme.

As the European crisis has rolled on, the European technocrats have become increasingly committed to “private sector involvement” (PSI). At face value, the principle is sound. The use of public money to rescue private sector banks leads to moral hazard. If lenders to banks expect to be bailed out, they may be tempted to allow banks to be ever more reckless in their risk-taking.

When a bank suffers losses, there is a hierarchy that determines who will suffer losses. The hierarchy typically works like this: investors in the bank’s shares are the first lose their investment; next to lose are investors in so-called “hybrid debt” (not quite lending, not quite equity, this includes things like preference shares); if the bank has issued “subordinated debt”, investors in these securities come next, followed by “senior debt” providers (typically in the form of bank-issued bonds). Depositors are the last to lose money and retail depositors with small balances typically have additional protection in the form of deposit protection provided by the government or a government agency*.

Depositor protection is extremely important. Despite being private companies, banks provide a critical role for the smooth running of an economy and so cannot be left at the mercy of the “creative destruction” of capitalism. In today’s society it is not really possible to opt out of the banking system and simply being paid a wage requires a bank account. It would be impractical, inefficient and unreasonable to expect every retail depositor to analyse the financial health of their bank before choosing where to deposit their money. When a bank collapses, shareholders should lose money. Wholesale investors should lose money. Retail depositors should be protected.

This reality is not lost on the lawmakers of Cyprus and for over 10 years, Cyprus depositors have supposedly been provided with deposit protection on balances under €100,000. The details of the levy have not yet been finalised, but the initial proposal involves a levy of 9.9% on all deposit balances over €100,000 and 6.5% on all deposits below €100,000. Anastasiades has effectively said, Oh, that deposit protection scheme? Well we had our fingers crossed when we made that promise. That explains the weasel word “levy” or “tax”. Of course your deposits are still protected against losses. You will not suffer a loss, it’s just that there’s a new tax we’re bringing in…

As if this dramatic breach of faith was not enough, there is no moral justice here either. Like Ireland before it (and indeed Australia), Cyprus did see rapid growth of private sector debt in the lead up to the crisis. So why not levy the tax on reckless borrowers not prudent savers?

Cyprus should rue the day that it surrendered its sovereignty by joining the euro zone in 2008. Cyprus would still be facing economic challenges today, but it would be free to determine its own fiscal policy, stimulate the economy (if it managed to keep politically-motivated deficit hawks at bay) and, of course, it would be able to honour its promise to protect retail depositors.

* Before the financial crisis, Australian depositors had no deposit protection. The assumption was that prudential oversight of banks provided sufficient protection for depositors. That changed after the crisis and now deposits below $250,000 are protected.

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21 thoughts on “Cypriot sovereignty surrendered

  1. apj

    Gday Mule, it’s more than a little sickening that people who should know better don’t understand true sovereignty. That goes for the EU Commission and IMF in spades. They also don’t seem to understand sectoral balances, though I see the IMF has belatedly begun to recognise the obvious (with a sense of revelation). It’s also a portent of some black-swan type of event in the future when technocrats take over running countries (as has happened in Europe already), over and above democratically elected governments.

    Why would anyone leave money in Cyprus now? Or have they cut off that route too?

  2. Ken

    The Scandinavians in the nineties got it right. If a bank can no longer operate, government then takes it over, then when the crisis is over privatises it. Shareholders probably end up with nothing.

  3. Dan

    Been hunting around a bit. Is there any precedent for this kind of bank deposit levy? Or is it just a clumsy policy forced on a country which can’t devalue and can’t adopt a new currency (like Argentina).

  4. Kevin

    The main problem is that the Cyprus banking system is 8 times the size of its economy fueled mainly by various Russian entities who will now take the biggest haircut from this tax.The Cyprus govt does not want to see the Russians “depart” so think that a tax covering all deposits will “look” better ie to the Russians . Political misjudgement?

  5. Simon Rumble

    My assumption about the reason they went for this rather than, say, increasing income tax is that they have trouble actually collecting other taxes. Surely that problem must be solved or anything like this is just a band aid.

    This is the kind of tax that both sides of politics will condemn. For the Left it’s a regressive tax, catching people who randomly have extra money in their account (stories of people who’ve taken bank loans but haven’t spent it yet, now losing 10% of it but still having to repay the money) and pensioners’ savings, of course. The Right will just see it as theft by the government, and they have a point.

  6. Stubborn Mule Post author

    Simon, you make a good point that neither the left not the right will like this. Perhaps that’s another indicator that it is wrong?

    I don’t know that Cyprus has problems with income tax evasion, although it has certainly been criticised by other countries for being a haven for tax evaders from other countries to stash their cash.

    To cover the losses of the Cyprus banks you could come up with a whole host of arbitrary imposts (eg an asset tax levied on property and the like) but the fairest, although still painful, solution would be to protect all deposits below the €100,000 insurance threshold and hit the large depositors with much more. Locals have little choice to bank locally but, with the trouble with Cyprus’s banks hardly a secret, it’s fair to assume foreign depositors understood the risks. If the balances were big enough, it would be tempting to risk the appearance of xenophobia and only levy a tax on non-resident depositors. But maybe the government would prefer to upset Cypriot pensioners than wealthy Russians.

  7. Stubborn Mule Post author

    Dan, I’m not aware of any precedents. The closest would be the Greek haircut but that hit bond holders not small depositors. In Cyprus there just aren’t enough bank bonds out there to absorb the loss.

    Ken, the Scandinavian approach was effective. In Cyprus, shareholders will lose everything unless the banks’ assets recover. One detail of the levy that I didn’t mention is that depositors will be “compensated” by receiving shares in exchange for the levy (which makes a further mockery of calling it a “tax”), so if shareholders ever get anything, so will depositors. If they do implement this approach, at the very least the shares given to depositors should rank ahead of not equal to existing shareholders.

  8. IC

    A few quick points:

    1. The Cyprus Popular bank (I’m sure its anything but that at the moment) has close to no senior unsec and a sliver of junior unsec. Its slice of equity is pretty small and almost worthless.

    2. Aside from depositors the only other thing on the right side of the balance sheet is the ECB’s ELA. Looks like they wanted depositors to bail it out.

    3. However, the deposit levy is being structured as a bail in. Namely, depositors get shares worth the levy paid (each of which isn’t worth much – see point 1).


  9. Stubborn Mule Post author

    @IC there’s no doubt that the reason this issue has arisen for the first time in Cyprus is the there is far less loss absorption capacity ahead of depositors. In Greece, senior debt-holders took a haircut in part so that depositors would be protected. The thing I really object to is that hitting the depositors below €100,000 makes a lie of their deposit protection scheme. If depositors are to be hit, hit those over €100,000 with a levy of 16% (or whatever is the required increase to cover what is proposed to be raised from the smaller depositors). Quite apart from the rights and wrongs, it defeats the whole objective of depositor protection, which is to calm panic and avoid the bank manager’s nightmare of queues of scared depositors outside the bank. If they go ahead with this plan, what is to stop small depositors in Spain or anywhere else in Europe. After all, Cyprus will have proved that the soothing promises of governments are worthless!

  10. Stubborn Mule Post author

    One suggestion made by a colleague today was that part of the reason for hitting deposits below €100,000 is to capture deposits from clever Russian oligarchs who spread their money across multiple accounts to ensure it was all covered by the deposit protection scheme. If this is the case, it is the right aim, wrong method. Instead, the levy should apply to deposits over €100,000, in exchange for equity (a special share class ranking ahead of existing share-holders). Then all banks should be instructed, as part of the terms of the bailout, to conduct an account aggregation review. To the extent that multiple accounts are found to have the same beneficiary, these should be aggregated and any excess above €100,000 should be subject to the levy. The money raised in this way could be returned as a cash dividend to holders of the new share class. This way, over time the levy applied to the larger depositors could be lowered to the extent that this money spreading was taking place (or at least proved to be taking place).

  11. IC

    I understand the concern there with depositor insurance and haven’t really commented on that. I’m not sure what I think about that quite yet.

  12. Kevin

    Cyprus has not arrived at its current situation because of Russia,IMF,ECB or Gernany. It has been caused by Cypriot banks’ investment decisions ie in Greek Bonds.
    The cost of repair has to be carried by the Cypriots one way or another and if not who else and why?. If they can get the Russian oligarchs to subsidise the cost then that is great but if not it must fall back on the Cypriots the whole 850,000 of them !

  13. Stubborn Mule Post author

    @Kevin the “who else and why” question has, in my view, a simple answer, Who: depositors with balances over €100,000. Why: depositors with balances below €100,000 were supposed to be protected by more than just the liabilities of the bank, but by a legislatively enacted deposit protection scheme provided by the government. It is the reneging on that promise that riles me up.

  14. Stubborn Mule Post author

    @Kevin the risk the proposal poses for banking across the region, as outlined in the Economist article in an earlier link, provides additional backing for the “why”.

  15. Danny Yee

    There’s an occurence of “on balances over €100,000” which should be “on balances below €100,000”.

    The basic argument seems solid to me. Bondholders should be wiped out completely, then accounts over €100,000 and then small depositors.

  16. Stephen Richards

    Mule, I know that was a rant, and we all love a good rant, but when it comes to loss of sovereignty, a better rant might be at the sort of tax arbitrage enabling the accumulation of $20 trillion dollars into tax havens like Cyprus?

    The sort of tax arbitrage the Australian Majors were up to their necks in just a short while ago?

    Now that’s something to rant about :)

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