XIV. Cyprus Bank Bailout Conclusions

Some commentators believe Laiki and Bank of Cyprus have been treated more harshly than previous troubled Eurozone banks.  Furthermore they believe that the way in which the bank bailout was arranged in effect and unneccessarily destroyed the Cypriot banking system.

ESM and Spain, Greece and Ireland

Presumably they believe that the ECB should have advanced European Stability Mechanism (ESM) or European Financial Stability Facility (EFSF) funds to assist in the recapitalisation of the banks. This was done in Spain and Greece, for example, through bodies they had each set up to engineer an orderly resolution of the banking crisis.

In Greece and Spain bail-in losses by senior bank bond holders have been small and even amongst junior bond holders losses are estimated at 10% of the recapitalisation needs of the banks in question.

More generally, particularly with Greek case, losses have been imposed on sovereign bond holders rather than bank bond holders.

In Ireland significant losses were forced on senior and junior bank bond holders through a special law that is still contested in Irish court. 

(See Hans-Joachim Dübel 'After the ‘Whatever-it-takes’ Bail-out of Eurozone Bank Bondholders' 2013 at Finpolconsult.de).

Intimations of a depositor bail-in

The first sign that a depositor bail-in was a serious possibility in the Cyprus case occurred when a meeting of European finance ministers was presented with a highly confidential report on options for the Cyprus bailout in February 2013 (See FT Spiegel and Peel 10 February 2013).

These seems to have been tabled because there was concern that 'the current rescue plan is not sustainable' (see Peel FT 11 February 2013).  (There had been some initial discussions and agreement between euro zone officials and the government on Cyprus's 2013 budget - see these referred to in Annex 1 of the 9 April 2013 provisional draft of the Memorandum of Agreement). 

The February 2013 paper put forward three options.

The first proposal - the radical one - was for a “bail-in” of investors, uninsured depositors, a 50% haircut on government bond holders and a drastic shrinking of the Cypriot banking sector.

This was intended to 'produce a more sustainable debt solution for the country, cutting the size of Cyprus’s bailout by two-thirds – from €16.7bn to only €5.5bn – by involving more foreign depositors and bond holders'.

This option was also seen as answering German criticisms of Cyprus as a tax haven for huge Russian capital flows and a centre of money laundering (see The Russian Connection and Russian Connections).

A second more moderate option onvolved a bail-in of junior debt holders - apparently including those Cypriots sold €1.2bn of convertible bonds by Bank of Cyprus and Laiki Bank - along with rises in corporation and capital witholding taxes and a favourable restructuring of Cyprus's €2.5bn loan from Russia.

The third option proposed that Cyprus be allowed to sell the shares it had bought and would acquire in its ailing banks to the European Stability Mechanism.  This was conditional however on the ESM being allowed to provide direct recapitalisation for banks; a development itself dependent on the rapid progress of EU banking union proposals.

Acute political controversy in the bailout

In an article the next day Quentin Peel (FT 11 February 2013) reported German officials' and politicians' concerns with Cyprus, including the vast amount of Russian money in the banking sector that made a bailout 'a matter of acute political controversy'.

The first bail-in proposal

The first bail-in concocted between the troika and the Cypriot authorities aimed to take a slice (levy or tax) of all bank depositors funds as a means to recapitalising Cypriot banks.

This went against the established (although how well established is another matter) principle of a creditor hierarchy and was rejected by the Cypriot parliament. A possible solution to the mysterious genesis of this proposal may come from Michalis Sarris's claim (he was the Cypriot Finance Minister at the negotiations) that he had proposed a tax on bank deposit interest and penalties for the early withdrawal of deposits (see Political Fallout.)

Bank recap loans plus government bailout equals unsustainable debt

The particular motivation behind the haircut attack on bank depositors in the Cyprus case was motivated by the ECB and IMF's view that a recapitalisation through borrowed ECB funds of Cypriot banks would have led to an unsustainable level of sovereign debt (€7bn for the bank recapitalisation and €10bn for the state bailout in the first round of negotiations) at 150-60% of GDP.

In 2011 Cyprus had a GDP of €18bn against which stood €12.7bn of accumulated public debt at 71.1% of GDP. It also ran a budget balance of € -1.132bn at 6.3% of GDP (Sapienta Economics Country Analysis- Cyprus January 2013 p.1).

Adding a full bailout (banks €7bn plus public finance €10bn = €17bn) to this accumulated public debt would have resulted in a total public debt of €27.7bn, at 154% of 2011 GDP - a level considered unsustainable by the troika.

A bailout of €10bn would equal a public debt of €19.7bn or 110% of GDP. Martin Wolf's calculations say 130% of GDP (FT 19 March 2013).

The troika has aimed at a  level of public debt of around 100 per cent of GDP by 2020.

Where is that banking union?

Martin Wolf says that had a eurozone banking union been up and running direct bank recapitalisation would have occurred - presumably because recapitalisation through a banking union would not have led to an increase in Cyprus's public debt and additionally it would have also had a European bank resolution and regulatory framework in place (FT 19 March 2013).

Reckless Banks

From the facts available regarding the strategies pursued by both Laiki Bank and Bank of Cyprus in the 2000s they can hardly be seen as innocent victims of sovereign Greek bond haircuts.

Rather, both banks, fuelled by massive deposits undertook highly risky investments in Greek government bonds and the Greek corporate and domestic lending markets. Even by the standards of the global banking crisis the rush into a massive bet on Greek bonds looks foolhardy.

Although as the head of the UK's new Financial Conduct Authority, Martin Wheatley says, the culture in the City of London during the boom years was 'anything goes as long as the compliance officer doesn't say no' see FT Master 2 April 2013).

The size of the bank recap out of kilter with country finances

Had the Cyprus economy been bigger relative to the banks' activities and had its public finances not been both in deficit and deeply in debt maybe an alternative solution could have been sought through an ECB financed recapitalisation and subsequent increase in levels of public indebtedness.

Alternatively, had the banks in question had a greater reliance on bond finance rather than depositor finance  the recapitalisation costs could have been pushed onto senior and junior bond holders (although the English law issue of bonds in Cyprus opened them up to litigation). But this was not the case.

Loss of trust and deposits after bungled first bailout

The problem with funding recapitalisation through depositor haircuts is that it undermines trust in the banking system across the board. The confusion and amateurishness of the first bailout attempt fatally weakened depositor faith in Cypriot banks and combined with the second bailout gave rise to the need for capital controls to stop a run on the banks and deposit flight.

The combination of these controls, the freezing of large €100,000+ deposits and closing the banks for 10 days has had the effect of bringing the Cypriot economy to a crashing halt.

Hugo Dixon (above) makes a fair point that the resolution of Laiki has been inconsistent in that Greek uninsured depositors (say 37% of the total other things being equal) paid no haircut and instead their 'share' fell on Cypriot depositors (the same can be said of uninsured depositors at Laiki's three UK branches although the total sum of deposits was relatively small at €270m).

The same can be said for the exemptions from the deposit haircut the resolution authorities in Cyprus have announced without justifications.

There is also the issue of the disposal of Cypriot banks' Greek branch networks sold at fire-sale prices to a Greek bank that had been a direct beneficiary of EFSF funds denied to Cypriot banks.

The compressed timeframe caused by government delays

Perhaps if the crisis of Cypriot banking had been dealt with in a more timely manner by the Cypriot regulators and the banks themselves these issues would have received greater consideration in a less compressed time frame.

As it was Laiki Bank had been kept staggering along (a-dead-man-walking) for nine months with €9bn of emergency liquidity funding (ELA) in order to get the elections and the increasingly fantastical bailout strategies of President Demetris Christofias out of the way.

By the time President Anastasiades took up the reins of power the ECB, IMF, Germany, the Eurogroup of Finance Minsters and its chair, Jeroen Dijsselbloem wanted quick and decisive action.

Action came but it was muddled and inchoate and infected by growing tensions between the IMF and the European Commission, the impact of the German political cycle on the bailout, German public attitudes, and tensions within the Cypriot negotiating team.

Even then valuable time was squandered chasing after Russian 'solidarity'. By the time the final act of the drama was being played out on Sunday night March 24th it was all the Cypriot negotiators could do to hang on to the Bank of Cyprus and keep it out of resolution.

Few in Cyprus may agree, but the island state has got the best deal it was entitled to expect. This was not the morality play rolling across media bulletins that paint the country as an innocent victim of European highhandedness. It chose a high-risk strategy of living off a banking system far bigger than the state could support. Two years after Nicosia lost market access, the banks still have books seven times Cyprus’s annual economic output. Even proportionately small losses are unaffordable for the state to make good.

If there is unfairness in the bail-in where does it lie?

From what I can gather Laiki bank was a dead-man-walking, propped up with €9bn of ELA funding.  Its downfall had started with its takeover by Marfin Investment Group in 2006 and the shift that took place from sleepy retail bank to reckless investment bank extending loans primarily to the Greek corporate and residential sectors, along with loans-for-MIG-shares schemes that troubled some bankers and the Greek and Cypriot Central Banks.

With regard to the Bank of Cyprus its loan book began to sour in 2009 and it took a massive and disastrous bet on Greek sovereign bonds through what has been called an 'abusive carry trade' where ECB long term refinancing operation (LTRO) funds  at low interest were used to buy highly discounted Greek bonds (see FT Alphaville   April 5 2013).

As the lessons from the UK show Cypriot banks can claim no monopoly in reckless and disastrous banking decisions.  Indeed the folly of the Cypriot banking sector - Russian funds notwithstanding - stands up well when placed against the cases of Northern Rock and HBOS. 

The removal of prudential constraint, moral shackles and lax or light-touch internal risk-management and external supervision was a widespread phenomenon in the run up to the crash into the Great Depression that started in 2008-9.

That Cypriot banks extended their recklessness that little bit further into 2010-11 speaks to special weaknesses in Cypriot bank regulation and to probably heightened political interference in that process - vis the souring relationship between President Demetris Christofias and the governor at the Central Bank of Cyprus and his replacement in May 2012.  The distractions and economic shock of the Vasilikos explosion in 2011 (see Economic Crisis) and Cyprus's assumption of the EU rotating presidency in July 2012 did not help.

So far. So fair.

The final bail-in solution arose from the absence of progress on European banking union, the absence of a bank restructuring/resolution intermediary in Cyprus - as existed in Spain and Greece - as a conduit for EFSF funding, the absence of a bank resolution law (this was hastily adopted by the Cypriot parliament between the first and second bailout) and the continuous delays and 'anything-but-Europe' efforts of the previous president.

When the crunch came there were not many places to go. Cypriot banks had few bondholders or senior creditors to clobber and the juniors were largely unfortunate retail bank customers and, at least in the case of Laiki, the banks own employees cajoled into buying worthless convertible bonds and shares while their directors allegedly sold up and moved on (see my blog post of 17th April 2013). 

With the government locked-out of bond markets and up to its neck in accumulated debt and budget deficits some kind of bail-in seemed inevitable.  There has been talk of a tax on deposit interest and escrow arrangements but this was presumably kicked-out at the first bailout meeting of European Finance Ministers: trying to lasso that bolted horse seems a folly of restrospective wishful-thinking (see this Ledra Capital blog for a discussion).

The areas where the troika played fast and loose that concern me are the way in which,

a) all depositor haircuts have been concentrated on deposits held in Cyprus. That is, depositors in the Greek branch networks (and the much smaller UK operations) of Laiki and Bank of Cyprus got-off scot free even though many of the problems in Cypriot banks had their origins in Greece;

b) the forced sale of the Cypriot branch networks in Greece (that included banks that were not implicated in the immediate bailout) resulted in a fire-sale price that according to some estimates equated to a measly 19 per cent of their net value;

c) the sale of the Greek branch networks to Piraeus Bank, that had been the beneficiary of €4.7bn bonds from the European Financial Stability Fund via the Hellenic Financial Stability Fund, seems wholly inconsistent.  Particularly as the Greek government then pledged an extra €1.5bn funding to assist in the adequate capitalisation of of the new Piraeus acquisition.

d) the hobbling of the rolled-into-one Bank of Cyprus/good Laiki bank with €10bn of Emergency Liquidity is particularly unfortunate.  I have charted eleswhere (see Not so lucky Laiki in my blog post of 27th April 2013) the disastrous merger of the Greek and Cypriot operations of Laiki bank and suggested this led to a masive shift of the Laiki's central bank obligations from the Bank of Greece to the Central Bank of Cyprus.  This occurred before the bailout in March 2011.

It is unclear (but seems unlikely) if any of the Central Bank borrowing undertaken by Laiki to cover the worsening position in its Greek operations was transferred to the Bank of Greece or Piaraeus Bank when the latter acquired Laiki's Greek operations (that at the time accounted for 50% of its loan book).  

That the whole bailout process has been both amateurish and bungling is I suspect both a consequence of the high-handedness of those officials and Finance Ministers involved, divisions in the troika, the re-emergence of powerful officials in the IMF and elsewhere, and last but not least, a lack of preparation and divisions within the Cypriot negotiating team - the farce of sending Sarris to Russia between bailout deals, his tendered and unaccepted resignation and the placement of time-served but inexperienced Haris Georgiades as Finance Minister do not speak of a happy team whilst the erosion of the credibility of the Central Bank governor, Panicos Demetriades opens up a whole other can of accountability and competence worms.

It remains to be seen if legal challenges and political pressure can roll back any of the decisions with regard to the Greek branch disposals.  Others talk of debt restructuring possibilities although the draft Memorandum seemed to have pre-empted that avenue. 

Maybe more hopeful is the careful mobilisation of a widespread feeling in the European parliament and elsewhere that Cyprus has been treated in certain well-defined areas with undue harshness. Quite what that can achieve is a question of politics and imagination and maybe side-deals concluded away from the harsh glare of the German political cycle - on such things as structural and special funding, assistance with gas exploitation and maybe even moves to resolve the 'Cyprus question.'

I have not been a great fan of the Cypriot model of development and share concerns about Cyprus's status as the great source of foreign direct investment into Russia.  The system has clearly been tightened up since the days of Deutsche Mark deliveries to Laiki bank's Larnaca branch in suitcases from Slobodan Milosevic in the UN embargo-busting days of the 1990s but legitimate concerns remain about light touch regulation and corruption (see the recently released Transparency International Cyprus report

The annoying but nevertheless understandable debate about respective levels of German and Cypriot household wealth and income and the cries of hypocrisy with regard to money-laundering and tax-haven status are sideshows that play well in the public arena and risk spiralling out of control (see my blog posts of April 11, 16 and 17 2013).

The upcoming Cypriot parliamentary vote on the bailout after the overwhelming German parliamentary approval of it will, it seems, take Cyprus to the brink again.  I personally feel that exit from the Euro would be a disaster for Cyprus in both the short and long term.  But that it is for the President and the parliament as representatives of the people of Cyprus to decide.