Is the decision by the Troika to bail-in Cyprus' depositor a game-changer for the euro crisis? Will it incite pan-European bank runs and accentuate the crisis though deposit outflows?
The bail-in will be in the form of a tax on depositors: a levy of 6.75% on deposits of less than 100,000 euros (the ceiling for European Union account insurance) and 9.9% on those above. The measures are expected to raise 5.8 billion euros out of a total bailout of 13 billion. Depositors will be compensated by banks' equity. Whatever the name (a wealth tax), it is a bail-in of depositors.
The idea of bailing-in the private sector has been part of the eurozone crisis resolution arsenal since the Spanish strain last year. However, involving private depositors had never been explicitly mentioned (even though the rumor of a possible bail-in of Cyprus' depositors is not new).
Such a decision has several features:
Moral: Cyprus is well known for its (Russian) money laundering. The decision can be seen as reluctance by Northern European countries to bail-out non-resident beneficiaries of a very lax financial system (elections in Germany will take place in September).
Yet, by avoiding mandatory losses on banks and sovereign bond holders, Cyprus depositors will bear the brunt of the adjustment.
Financial: The huge inflows of foreign deposits have skewed the liability side of the Cyprus banking system: the outstanding of senior and subordinated debt is miniscule in comparison with deposits (less than 2 billion euros, compared to 73 billion of deposits and 14 billion of loans from eurozone banks).
One of the reasons why Cyprus' banking system is in such a bad situation is because short term deposits were used to purchase Greek government bonds. The Greek PSI implemented last year led to a capital shortfall that cannot be dealt with by bailing-in bond holders.
The reason why the option of a PSI "a la Greek" was not implemented is that domestic banks hold 53% of the sovereign debt outstanding. The negative feedback loop between banks and sovereigns would not have been broken.
For the record, ex-eurozone deposits amount to 21 b EUR (mostly denominated in USD). Ex-Cyprus euro depositors hold 5 b EUR. Cyprus citizen own 43b EUR of deposits.
Legal: taxing the deposits is a real game-changer as it reverses the creditor hierarchy: it makes depositors junior or at least equal creditors to bank bond holders, especially since there is no mention of a bail-in of bond holders.
The major risk behind the decision is the strength of the European authorities on their commitment towards deposit insurance. The Euro Group may have presented the idea as exceptional, but it may nevertheless spur a further decline in some countries' bank deposits (still falling at a pace of -10% in Spain).
If history is a guide …
Five years ago in 2008, Iceland resorted to the IMF to make sure that its depositors would not lose anything from the collapse of its banking sector. The Icelandic parliament granted priority to depositors over any other claims on the domestic banks.
Even if today's hidden targets are foreign deposit holders, the taxation of all depositors poses a real threat not only to the fate of Cyprus' economy but also to the interpretation of such a radical move by market participants.
Risks
The biggest risk is clearly that of an across-the-board eurozone defiance towards government-insured deposits. It may encourage further bank deposit outflows. Monday will be a bank holiday in Cyprus, which could foster social anger against the move.
Markets may also question the positives of such a deal as it shares many of the costs of an exit without any of the advantages. If the plan is rejected by members of parliament, it would increase domestic political pressures: the President Nicos Anastasiades said a "No" would spur an exit.
European authorities are experiencing crisis fatigue, and with such a move, they seem ready to take on the risk of contagion, as nobody will believe that this is a traditional "one-off" decision. In its endeavor to alleviate the potential burden on European taxpayers (even though Cyprus GDP makes up a little bit more than 0.2% of the Eurozone's GDP), the Troika has opted for a political risk that may be harder to handle in case there is some contagion.
The European authorities do not want to repeat Greece's mistake. Still, had a real banking union been in place (supervision, resolution and deposit insurance), the Cyprus crisis would have been much easier to deal with.
Market Implications
The plan might not be implemented as described. There might be some setbacks. But a precedent has been created and the damage is done. We would not play the doomsday scenario, but the Troika did whatever it takes to spur another round of huge volatility within the eurozone.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
