The Cypriot crisis provides two reasons to be jealous of those EU countries which chose to remain outside the eurozone. The first is that it was poorly designed, as is now acknowledged even by the designers. The second is that it has been managed in such an amateurish fashion. The shambolic handling of the Cypriot request for a bailout, first made last summer, is further evidence of mismanagement. This was not a poor decision made on the hoof under severe time pressure. This was a designer cock-up eight months in the making, and could readily have been avoided.
The essential design flaw in the eurozone is that it is not really a monetary union; it is just a common currency area, lacking the essential feature that ensures financial integration, namely a banking union. The latest piece of mismanagement over Cyprus makes the attainment of a banking union, on which progress has been negligible, even more difficult.
The Eurogroup decision on Cyprus, taken (yet again) at 3am on a Saturday morning, has rendered meaningless the repeated assertions that deposits in eurozone banks are guaranteed up to €100,000. The 'guarantee' has never been a joint eurozone undertaking, since it is the responsibility of each individual government, several of which are bust and would be unable to meet large claims. Unlike the deposit guarantee system in the United States, the eurozone countries collectively do not have an actual deposit guarantee fund in place, and the volume of deposits in many eurozone countries, not just those already in financial distress, is large relative to the fiscal capacity of the state. Bank runs by retail depositors are a serious risk, particularly in those countries whose governments lack financial credibility.
The eurozone agreement to guarantee smaller deposits in the months following the banking collapse in late 2008 helped to forestall bank runs. The public were persuaded that deposits in eurozone banks were safe: the governments would guarantee them up to €100,000. The small print actually said that the governments would reimburse depositors only if the bank was bankrupt, but the public is never encouraged to bother about small print. The message, given and received, was that deposits under the limit in eurozone banks were safe. There was no mention of levies or taxes on deposits in banks that did not go under.
The Cyprus decision last weekend made the pretence official: we were only joking, folks, a portion of your deposits in Cypriot banks could be confiscated, guarantee or no guarantee. Depositors in Greece, Spain, Italy, Ireland and any other country with damaged banks will no doubt take notice, and the risk of bank runs has been magnified. Unforgivably, this seems to have happened by accident, and Cypriot banks are closed until Tuesday for fear of deposit flight. The parliament refused to accept the deal and the matter remains unresolved.
There was some frantic spin-doctoring last week, especially in Germany, designed to divert attention from the flawed handling of the problem in Cyprus. A short-hand version is that Cyprus is an offshore money-laundering emporium for the Russian mafia, the Cypriot public are responsible for this, and thus should pay, in the form of a partial confiscation of whatever funds they held in the local banks when the eurozone finance ministers stopped the music.
At least one-quarter of the bank deposits held in Cyprus are believed to belong to individuals and business firms from Russia and the Ukraine. Some of them may be laundering ill-gotten gains, but nobody has ever established that this is the case. There are lawful tax advantages for Russians who keep their savings in Cyprus, and for all we know most Russian depositors in Cyprus are perfectly legitimate. Under money-laundering rules which apply across the EU, criminal proceeds, if proven in a court of law, are liable to 100 per cent confiscation, and nobody could have objected to that. There have been no such proceedings and no 100 per cent confiscations. If all the non-EU deposits (about €20bn) represented criminal hot money illegally laundered into Cyprus, it could all, after due process, be seized by the Cypriot authorities and there would be no need for any bailout.
The reason that this has not been done is that the 'Russian mafia' story is a smokescreen. It is a reasonable guess that money has indeed been laundered into Cyprus. But consider the following: HSBC, Europe's largest bank and the owner of the Midland Bank in the UK, has paid $1.9bn in fines to US regulators over money-laundering violations. Standard Chartered has been fined $667m over sanctions-busting. The New York Times has pointed the finger at two of America's largest banks, Bank of America and JP Morgan, alleging the US Treasury suspects them of money-laundering offences. The Swiss bank UBS is under investigation, as is Germany's Deutsche Bank. The notion that little Cyprus is infecting the blameless paragons of virtue that dominate European banking is a kind of blood libel. How clean are the bank deposits in Switzerland, or Luxembourg?
The Cypriot government is not actually bust by current European standards. It has a debt/GDP ratio no worse than France or Germany. The problem is the banks. They have gone bust (some more than others, and some not bust at all) because they suffered large haircuts on holdings of Greek government bonds in the EU-sponsored default in March 2012. They have had other losses too, including property lending in Cyprus which has gone sour, but the larger Cypriot banks were doomed by the terms of the Greek sovereign default as everyone knew at the time. They should have been recapitalised as part of the Greek deal. In best European tradition, the Cypriot can was kicked down the road and the inevitable endgame has come 12 months later.
Cyprus sought €17bn in loans to the government from the EU and the IMF, enough to finance the state and also to recapitalise the banks. Providing such a large amount would have pushed Cypriot state debt to quite unsustainable levels, the original sin committed at the time of the first Greek bailout in May 2010. The IMF insisted, quite rightly, that an upper limit for official loans was €10bn: to lend more would have ensured a second bailout a la Grecque in due course. The question then is how to find the missing €7bn.
The first resort in any sensible bank recapitalisation is to wipe out the equity shareholders in the bust banks. This, unbelievably, has not yet been done: the depositors were even offered equity stakes in bust banks in return for the funds confiscated from their accounts. Next in line should be the junior (subordinated) bondholders, followed by senior bondholders, and ultimately uninsured depositors. The Cypriot banks have just €0.2bn in senior unsecured bonds, to be spared any haircut, and €2.5bn in junior bonds, subjected to an undisclosed haircut. Most of the €7bn gap was to be bridged through a levy on deposits, including those under €100,000 supposedly not at risk. The normal order of creditor preference was simply torn up.
It gets worse: some of the smaller Cypriot banks, including local branches of solvent British and Russian banks, are not actually bust at all. People who were careful enough to select these non-bust banks as the home for their savings could face the same haircut as depositors in the large banks that have actually gone wallop. Insured depositors in banks that are not bust were to suffer haircuts in order to reduce the haircuts for uninsured depositors in banks that really are insolvent.
Banks are fragile institutions at the best of times. One of the golden rules, namely 'never touch insured depositors', has been solemnly broken, with the agreement of the eurozone's finance ministers. The damage has been done and cannot be undone whatever revised formula emerges in Nicosia, Moscow or Brussels. Of course a major Cypriot industry, namely offshore banking, is toast, and Cyprus faces a deep and prolonged recession.
Cyprus is a tiny country whose economy accounts for one-fifth of one per cent of the eurozone's GDP. It may matter only to Cypriots whether it sinks or swims but the manner in which it has been treated matters a lot. Financial stability is about confidence. Tearing up promises to insured depositors is not just unfair; it is yet another massive policy blunder.