Investors have enjoyed six months of relative quiet in Europe, but the situation flared up again last week over Cyprus. Many investors are wondering why they should care about such a tiny part of Europe, representing just 0.2% of European GDP? The answer is because it is indicative of a bigger concern: the still fragile nature of the European banking system.
First, some background. Cyprus has run into trouble, not because it’s like Greece, burdened by a profligate public sector, but because it’s more like Ireland, with a banking sector that is too large relative to the size of the overall economy.
The bailout that was announced early on Monday morning should help stabilize the country in the immediate term, and because the package is designed to shrink the size of Cyprus’ banks, it should provide some longer-term relief as well. As with the stopgap measures put into place throughout Europe over the past couple of years, however, the deal will certainly not solve all of the issues.
Cyprus itself still faces a significant recession and Europe’s banking system as a whole remains undercapitalized and vulnerable to shocks. While the EU has technically agreed on tighter banking integration, implementation has been slow. Unfortunately, with German elections pending in September, we are unlikely to see much compromise on this politically contentious topic until late this year or early next.
In the meantime, Cyprus will probably muddle through. But European banks will probably remain a source of systematic risk for the rest of the year.