Sowing The Seeds For A Bank Run

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Includes: EUFN, FXE, GREK, SPY, VGK
by: Elliott Orsillo, CFA

"Bank failures are caused by depositors who don't deposit enough money to cover losses due to mismanagement." - Dan Quayle

In light of the buzz surrounding the tiny country of Cyprus over the last couple days, we thought it would be prudent to cover this developing story. Cyprus is making front page news due to some radical terms which the Troika (European Central Bank, European Commission, & International Monetary Fund) proposed for a bailout of their banking system. As background, Cyprus is a small island nation in the Mediterranean off the coast of Turkey (NYSEARCA:TUR) with a Greek/Turkish-speaking population of around 1.1 million people. It is best known as a tourist destination for its sunny beaches and as a banking hot spot for Russian (NYSEARCA:RSX) oligarchs. In a move to increase political and financial stability (oddly enough) Cyprus decided to join the European Monetary Union at the beginning of 2008.

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Like many other EU banks, Cypriot banks are in trouble today because they bought too much Greek (NYSEARCA:GREK) debt during the EU euphoria when investors thought all sovereign debt in the EU carried roughly the same amount of risk. Last summer, Cyprus made an official request for "external financial assistance" from the European authorities. Negotiations stalled last year after the previous government objected to the conditions being attached to the bailout proposals. Negotiations restarted last month after the election of the new President Nicos Anastasiades. On Thursday, March 14th the Financial Times reported that President Anastasiades would "never" accept a deal that included a haircut to depositors. Over the weekend, a deal was struck to the contrary that levied a "tax" of 6.7% on all insured deposits (accounts under 100k EUR) and a 9.9% tax on all uninsured deposits (accounts over 100k EUR). By proposing this, European (NYSEARCA:VGK) authorities were essentially taking Vice President Quayle's opening quote to heart that the onus of bad decision making by bank management should fall squarely on its depositors.

As of this afternoon, the Cypriot parliament voted down this proposal in a brinkmanship move betting that the European authorities would not let them fail and leave the Euro (NYSEARCA:FXE). No more than an hour after the vote, the ECB caved under the guise of restoring confidence to the banking system (NASDAQ:EUFN) when they announced that they would provide liquidity to Cyprus as a lender of last resort. It remains to be seen if this2013-03-19_ATM_line2.png announcement is an adequate solution or whether it just buys everyone a little more time. Until funding for Cyprus is finalized, banks will remain closed to prevent any sort of run and citizens will continue to line up outside of nonfunctioning ATMs in hopes that they might somehow get their money out.

However this mess ends up finally being resolved, it is safe to say that damage has been done. European officials promised that this one-off proposal for Cyprus was unique due to extenuating circumstances, but who can really trust what they say these days? After all, back in 2011, the Prime Minister of Luxembourg Jean-Claude Juncker (while trapped in a lie) stated, "When it becomes serious, you have to lie." Many market pundits have begun to question whether this proposal could have knock on effects for other countries in Europe. After all, if the Troika can require the people of Cyprus to take an overnight haircut, what is to stop them from someday requiring the same of depositors in Portugal, Ireland, Spain, Italy, or any other European nation?

The proposal was a very bold move since it risked a major destabilization of the banking system. Depositors would have little reason to keep their money in Cypriot banks if they feared that more haircuts could be forthcoming. The proposal would have effectively eliminated the EU-wide deposit insurance that was put in place after the Lehman Brothers default in 2008. Prior to deposit insurance here in the U.S. (NYSEARCA:SPY), bank runs were very common. After the Great Depression, deposit insurance was instituted to restore confidence in the banking system (NYSEARCA:XLF). Because banks make loans well in excess of their deposit base, their reputation and the confidence of their depositors is paramount to their success. When depositors become less confident in the safety of their money, they have a tendency to pull their money out of the bank in favor of safer options like their mattress or gold (NYSEARCA:GLD). When this happens in droves, one has a bank run on their hands. The question is why the Troika would take such a risk rather than just forking over the 17 billion Euros in requested bailout funds like they did for Greece on a much larger scale multiple times over. The answer may have everything to do with German (NYSEARCA:EWG) politics. In a recent research note, Chief Market Strategies at Jeffries & Co. David Zervos shared his opinion on the reason for the radical terms in this tongue-in-check quote:

The German elections are coming up quickly, and Merkel needed to quiet the opposition. She needed to appear tough - not like a leader who would just throw away hard working German taxpayer euros to a bunch of Russian tax dodgers. The plan was simple - haircuts on deposits. The German electorate would applaud her bold actions. She would be teaching the bad guys a lesson. And what could go wrong?

As of this afternoon, Merkel has bought some political good will with her electorate, Cyprus has some more time with an olive branch from the ECB, and Mario Draghi got to make good on his promise to do "whatever it takes" to save the euro. The question is at what cost was this potential solution forged? Time will tell, but episodes such as this are constant reminders of the fragility underlying the confidence game that is the European banking system.

Original Source: Recipe For A Bank Run

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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