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It's like money in the bank
Mar. 18th, 2013 02:34 pmThe number €30bn is going to crop up more than once in this piece. It's the key figure in the mandatory "bail-in" of the Cyprus Banks, which the Cyprus government appears at the moment to be having difficulty getting through the Cyprus parliament.
We can come later to the (potentially profound) implications of this hit on depositors with Cypriot Banks. But let's look first at how it happened and why it happened.
One reason that we have not had many runs on banks since the Second World War is that lessons were learnt from the depression of the 1930s in the US (when many banks failed that were not insolvent, simply because no-one trusted any banks at all) and from watching the film It's A Wonderful Life.
As George Bailey (James Stewart) observes when depositors come asking for their money back:
To prevent this "madness of crowds", deposit protection schemes were invented. Under these systems your deposits were protected by a government guarantee, up to a certain amount. This meant, the theory went, that solvent banks would not be sent under by public panic. And, because banks were actually fairly solid institutions, that meant the deposit protection scheme, by its very existence, would not be needed.
You can possibly see the flaw in this line of thought. What if, heaven forbid, a bank WAS insolvent?
The impact was that there still wasn't a run on the bank, because, hell, the money was guaranteed, so it didn't matter a toss whether you banked with a solvent bank or an insolvent bank. So long as the amount you deposited with them (i.e., lent to them on an unsecured basis) was guaranteed by the government, there was no need to withdraw the funds.
This had two effects – both of moral hazard. One was that it encouraged depositors to deposit recklessly, and the other was that it encouraged banks to lend recklessly.
Now, if a bank actually IS insolvent, eventually it won't matter if there's a run on the bank or not; it will still go bust. And, in Cyprus, Laiki, the country's second-largest bank, was very, very bust. Bust to the extent that the cheap ECB loans that have been used by several zombie banks in the weaker parts of the eurozone for day-to-day operations were no longer available to Laiki. And, if Laiki went, then the Bank Of Cyprus would go too. That would be about 50% of the Cypriot banking market.
The Deposit Protection Scheme would stop functioning as it was meant to function – as a scheme that would never be needed because it provided the confidence that would be enough to keep the banking system stable – and would actually come into play as a protection for depositors.
And it was at this point that the Deposit Protection Scheme in Cyprus was proved to be a fraud. Because the collapse of the two largest banks in Cyprus would cost the government €30bn, And the Cyprus government didn't have €30bn.
If the Cypriot government did have €30bn, it would have nationalized the two banks, guaranteed the deposits, and the system would have continued. This is precisely what the UK did on the weekend of October 2008 when RBS was on the verge of having to close its doors.
But, the Cypriot government didn't. It was broke. That was why it was having the "bail out" talks leading up to last weekend, looking for €17bn.
At last the Finns, who have been itching to get at southern Europe for its profligate ways ever since the crisis erupted, saw an opening. After all , much of the money deposited in Cypriot banks was said to be laundered Russian money, a benefit of rather lax oversight procedures when it came to asking where the cash came from. By insisting that depositors take a €7bn hit of the €17bn bail-out, and allocating them "shares" in the banks in return, it could be argued that the right people were being penalized.
As it happens, the amount of money the Russians have invested in Cypriot banks is, about, €30bn. That in effect means that the haircut imposed at the weekend amounts to a €3bn expropriation of Russian cash. It's a staggering act of protectionism that verges on piracy. It certainly won't do much for cross-border trade between Russia and the EU.
The haircut (a "bail-in" of depositors into the banks because a loan is turned into a shareholding) also cut out the bankrupt middleman. Because Cyprus could not offer cash to depositors and take on the shares itself, it has transferred the (probably worthless) shares directly to the depositors.
It is, in effect, a sovereign default, passing to unsecured creditors some probably worthless paper instead of cash. The alternative for the government would have been a double banking collapse and either a complete wipe-out of all deposits, or a complete wipe-out of the Cypriot government debt.
At the time of writing, the vote in the Cypriot parliament has been postponed, indicating that it might not get through if the haircut remains as originally proposed. I would not be surprised it the banks didn't stay shut again tomorrow. If the vote does not go through, then we have Cypriot financial armageddon. The banks fail. The government fails. The Sovereign Debt defaults. I don't actually see all of those things being allowed to happen. It could therefore be interesting to see how Germany and the Finns react if the Cypriot parliament (with Russian encouragement?) votes down the proposal, and Russia then starts flexing its diplomatic muscle.
This has been a victory for the IMF, under Lagarde, over the European Commission and the ECB, under Barroso, although as victories go this one could turn out to be more pyrrhic than most. And it all happened because in September 2000 a €100,000 deposit protection scheme was enabled without anyone actually thinking what this would signify were a bank to actually go bust.
+++++
There have been not a few commentaries already about the implications. From reading the above, at first glance one would have expected the euro to fall off a cliff on Monday morning. But it didn't.
Why not?
Because, basically, the IMF has found another way for a country to be broke without officially being declared broke. If by some chance the hit on depositors does not cause mass withdrawals from banks elsewhere. If the "Russian connection" could be played to a level that Cyprus was seen as a unique case, then the "solution" could be seen as euro-positive. Although the state of the disaster in Cyprus was thrown into sharp relief, the view was that, if the hammering of depositors could be pushed through, the euro was more likely to survive, not less. It would be a case of "someone else taking the pain" (€3bn Russia, €4bn to sundry others, including not a few British expatriates).
That's the good news. The flip-side is unremittingly bad.
The minor point is the impact on relations with Russia, a country which, remember, has a hefty degree of control over energy supplies. Finland was the loudest noise in favour of this solution (supported less manically by Germany and Netherlands) but one wonders whether they will be so enthusiastic about it if they woke up to see that Russia had sealed the borders and cut off Finnish/Russian trade.
The major point is the impact on the psychology of ordinary savers. It has just been demonstrated, quite explicitly, what some of us have been writing for several years. No matter how safe you think your wealth is, it isn't really safe. The confidence that "money in the bank" is 100% safe just vanished down the Cypriot plughole. No matter that Cyprus is a special case, that it had too many banks, too many pampered staff, made too many dubious loans, and basically were not very well-run. What matters is that people will no longer think that a bank in your own country is just about the safest place for your money to be. This isn't like a savings account with Kaupthing or Icesave. This is everyday cash from week to week, the account into which your wages are paid (remember, we no longer have the legal right to insist on being paid in cash).
For the first time in many years, the question can be asked rationally: "is my money safer in the bank, or in the mattress?"
___________________________
We can come later to the (potentially profound) implications of this hit on depositors with Cypriot Banks. But let's look first at how it happened and why it happened.
One reason that we have not had many runs on banks since the Second World War is that lessons were learnt from the depression of the 1930s in the US (when many banks failed that were not insolvent, simply because no-one trusted any banks at all) and from watching the film It's A Wonderful Life.
As George Bailey (James Stewart) observes when depositors come asking for their money back:
"The money's not here. Your money's in Joe's house...right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can.
To prevent this "madness of crowds", deposit protection schemes were invented. Under these systems your deposits were protected by a government guarantee, up to a certain amount. This meant, the theory went, that solvent banks would not be sent under by public panic. And, because banks were actually fairly solid institutions, that meant the deposit protection scheme, by its very existence, would not be needed.
You can possibly see the flaw in this line of thought. What if, heaven forbid, a bank WAS insolvent?
The impact was that there still wasn't a run on the bank, because, hell, the money was guaranteed, so it didn't matter a toss whether you banked with a solvent bank or an insolvent bank. So long as the amount you deposited with them (i.e., lent to them on an unsecured basis) was guaranteed by the government, there was no need to withdraw the funds.
This had two effects – both of moral hazard. One was that it encouraged depositors to deposit recklessly, and the other was that it encouraged banks to lend recklessly.
Now, if a bank actually IS insolvent, eventually it won't matter if there's a run on the bank or not; it will still go bust. And, in Cyprus, Laiki, the country's second-largest bank, was very, very bust. Bust to the extent that the cheap ECB loans that have been used by several zombie banks in the weaker parts of the eurozone for day-to-day operations were no longer available to Laiki. And, if Laiki went, then the Bank Of Cyprus would go too. That would be about 50% of the Cypriot banking market.
The Deposit Protection Scheme would stop functioning as it was meant to function – as a scheme that would never be needed because it provided the confidence that would be enough to keep the banking system stable – and would actually come into play as a protection for depositors.
And it was at this point that the Deposit Protection Scheme in Cyprus was proved to be a fraud. Because the collapse of the two largest banks in Cyprus would cost the government €30bn, And the Cyprus government didn't have €30bn.
If the Cypriot government did have €30bn, it would have nationalized the two banks, guaranteed the deposits, and the system would have continued. This is precisely what the UK did on the weekend of October 2008 when RBS was on the verge of having to close its doors.
But, the Cypriot government didn't. It was broke. That was why it was having the "bail out" talks leading up to last weekend, looking for €17bn.
At last the Finns, who have been itching to get at southern Europe for its profligate ways ever since the crisis erupted, saw an opening. After all , much of the money deposited in Cypriot banks was said to be laundered Russian money, a benefit of rather lax oversight procedures when it came to asking where the cash came from. By insisting that depositors take a €7bn hit of the €17bn bail-out, and allocating them "shares" in the banks in return, it could be argued that the right people were being penalized.
As it happens, the amount of money the Russians have invested in Cypriot banks is, about, €30bn. That in effect means that the haircut imposed at the weekend amounts to a €3bn expropriation of Russian cash. It's a staggering act of protectionism that verges on piracy. It certainly won't do much for cross-border trade between Russia and the EU.
The haircut (a "bail-in" of depositors into the banks because a loan is turned into a shareholding) also cut out the bankrupt middleman. Because Cyprus could not offer cash to depositors and take on the shares itself, it has transferred the (probably worthless) shares directly to the depositors.
It is, in effect, a sovereign default, passing to unsecured creditors some probably worthless paper instead of cash. The alternative for the government would have been a double banking collapse and either a complete wipe-out of all deposits, or a complete wipe-out of the Cypriot government debt.
At the time of writing, the vote in the Cypriot parliament has been postponed, indicating that it might not get through if the haircut remains as originally proposed. I would not be surprised it the banks didn't stay shut again tomorrow. If the vote does not go through, then we have Cypriot financial armageddon. The banks fail. The government fails. The Sovereign Debt defaults. I don't actually see all of those things being allowed to happen. It could therefore be interesting to see how Germany and the Finns react if the Cypriot parliament (with Russian encouragement?) votes down the proposal, and Russia then starts flexing its diplomatic muscle.
This has been a victory for the IMF, under Lagarde, over the European Commission and the ECB, under Barroso, although as victories go this one could turn out to be more pyrrhic than most. And it all happened because in September 2000 a €100,000 deposit protection scheme was enabled without anyone actually thinking what this would signify were a bank to actually go bust.
+++++
There have been not a few commentaries already about the implications. From reading the above, at first glance one would have expected the euro to fall off a cliff on Monday morning. But it didn't.
Why not?
Because, basically, the IMF has found another way for a country to be broke without officially being declared broke. If by some chance the hit on depositors does not cause mass withdrawals from banks elsewhere. If the "Russian connection" could be played to a level that Cyprus was seen as a unique case, then the "solution" could be seen as euro-positive. Although the state of the disaster in Cyprus was thrown into sharp relief, the view was that, if the hammering of depositors could be pushed through, the euro was more likely to survive, not less. It would be a case of "someone else taking the pain" (€3bn Russia, €4bn to sundry others, including not a few British expatriates).
That's the good news. The flip-side is unremittingly bad.
The minor point is the impact on relations with Russia, a country which, remember, has a hefty degree of control over energy supplies. Finland was the loudest noise in favour of this solution (supported less manically by Germany and Netherlands) but one wonders whether they will be so enthusiastic about it if they woke up to see that Russia had sealed the borders and cut off Finnish/Russian trade.
The major point is the impact on the psychology of ordinary savers. It has just been demonstrated, quite explicitly, what some of us have been writing for several years. No matter how safe you think your wealth is, it isn't really safe. The confidence that "money in the bank" is 100% safe just vanished down the Cypriot plughole. No matter that Cyprus is a special case, that it had too many banks, too many pampered staff, made too many dubious loans, and basically were not very well-run. What matters is that people will no longer think that a bank in your own country is just about the safest place for your money to be. This isn't like a savings account with Kaupthing or Icesave. This is everyday cash from week to week, the account into which your wages are paid (remember, we no longer have the legal right to insist on being paid in cash).
For the first time in many years, the question can be asked rationally: "is my money safer in the bank, or in the mattress?"
___________________________
