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After a 13th hour deal, Cyprus will get its 10-billion-euro loan. One cost is that the Cyprus banking system will be wiped out, except that deposits of under 100,000 euros will be protected. A second cost is that the Russian depositors will lose an amount that probably exceeds 5 billion euros-perhaps as much as 20 billion euros. A third consequence is that many Russian businesses will leave Cyprus. A natural fourth consequence is that the Cyprus economy will fall into depression and will have to be restructured along some new line. Will Cyprus be able to repay the 10 billion euro loan? Probably not.

Will these consequences be worse than they had to be? Probably. Probably the Cypriots would have been far better off accepting the fairly modest tax of 6.75% on insured deposits-or even more. By punishing the Russian depositors, the Cypriots will lose far more than they the deposit levy would have cost. But such is politics.

Should the IMF and the northern Europeans have been willing to lend to Cyprus without doing something about the Cypriot banks? No. That would have solved nothing and would have rewarded Cyprus for its incompetent use of flight capital.

What are the lessons from Cyprus?

  1. If you want to run a country that bases its economy on flight capital, make certain your banks are prudently managed and have plenty of equity capital themselves. The penalties for failing to do that are the death of your economic model and the impoverishment of your people.
  2. If your banks accept deposits in a currency you cannot print, then you must be doubly certain to observe rule number 1.
  3. Flight capital flees. It has no loyalty.
  4. The rest of the world does not like economies built on flight capital, and it will not bail you out when you have violated rule number one.

The Swiss know all this-or at least they know it now, after bailing out UBS in the recent financial crisis. And the Swiss banks accept deposits in a currency Switzerland can print, having convinced the world that the Swiss Franc is safe.

Will there be contagion from the Cyprus debacle?

Not a lot. Switzerland will not come under pressure. Spain also will not come under renewed pressure, except that, to the extent that foreigners have more than 100,000 euros on deposit in a Spanish bank, they are likely to take their deposits elsewhere. My guess is that most of them already have done so. The Spanish and Italian banks also will have more difficulty borrowing in the capital markets unless their own regulatory capital is quite strong.

Will anything good come of the Cyprus debacle?

Yes. A proper euro zone-wide bank regulatory and remediation scheme now is far more likely than it was last week. The way forward is not as difficult as the Europeans have been making it. The main point of contention has been whether northern European euros could be used to bail out insolvent southern European banks. That question always should have been answered in the negative. Now I believe the southern European countries, most notably Spain, will see that such a thing is not in the cards.

The new regime must have its own zone-wide deposit insurance fund, and no bank can gain membership in that fund unless and until it has been examined by the ECB and its regulatory capital has been found to meet the highest final European capital requirements. For such an insurance fund, the ECB can be a liquidity backstop.

Banks that do not meet the regulatory capital requirements will have to raise more equity. If they cannot do so, they will wither because the banks with zone-wide deposit insurance will have such a competitive advantage. After that shakeout, the European banks will be strong and will be a bulwark for their governments instead of a drain. But stockholders of weak banks beware: You will be deeply diluted or wiped out. There is no other possible scenario.

One thing that the euro zone banking system needs that will not happen (at least not soon) is a guarantee that the ECB will accept at face value all government debt denominated in euros having a maturity of less than one year that is owned by banks in the zone, up to 10% of the owning bank's assets. That really is essential for proper liquidity, but it is not even on the table, and it probably requires a Treaty amendment.

This morning every rich person with substantial assets in tax haven countries like Cayman and a dozen or so other islands are wondering whether their assets are safe. A part of me hopes they are not.

Source: The Lessons Of The Cyprus Debacle