A camel, it is said, is a horse designed by a committee. This is unfair to camels, which are well-adapted to their harsh environment. The same, alas, cannot be said of eurozone rescue programs. The proposed Cyprus intervention, rejected yesterday by the Nicosia parliament, will not help the eurozone make a smooth exit from its wave of crises. Indeed, the imbroglio should serve as a lesson in how not to deal with financial and sovereign debt problems.
Let us start with why some bank restructuring was inevitable. The government of Cyprus is both highly indebted and responsible for a banking sector that is surely too big to save. According to the International Monetary Fund, gross government debt reached 87 per cent of gross domestic product last year and would reach 106 per cent of GDP by 2017, without the bailout. The sovereign credit rating is also far below investment grade: Standard & Poor’s rates Cyprus CCC . That is not surprising: the banking sector still has assets over seven times GDP.
The banks stand on the edge of collapse. But it is the European Central Bank that has pulled the plug by threatening not to accept Cypriot government debt as collateral against liquidity support. Banks have to be recapitalised. Taxpayers cannot do this, on their own. Without taxing depositors, the proposed rescue package would have had to be €17.2 billion, instead of €10 billion, or close to 70 per cent of GDP. This would have brought sovereign debt to some 160 per cent of GDP: an unsustainable burden. Indeed even the actual bailout package looks unsustainable, since it would appear to have brought gross debt to 130 per cent of GDP. Under the program, public debt would fall to 100 per cent of GDP by 2020. Achieving that would demand substantial fiscal tightening and lending to Cyprus on easy terms. A restructuring of public debt is still likely. As Hamlet advises: If it be not now, yet it will come.
Is there no alternative to the bail-ins? Yes: direct bank recapitalisation by the eurozone, for which the sum required is a small matter. If the banking union had been up and running, that would have happened. It is not, presumably because core countries do not want to bail out mismanaged banking systems, such as the offshore hideaway for Russian capital that is Cypriot banking. The banking union will not arrive before the cleaning up of past mistakes and establishment of new arrangements.
Turn then to whether what was done was right. The answer is: yes, though only up to a point.
Many insist that any tax on deposits is theft. This is nonsense. Banks are not vaults. They are thinly capitalised asset managers that make a promise – to return depositors’ money on demand and at par – that cannot always be kept without the assistance of a solvent state. Anybody who lends to banks has to understand that. It is inconceivable that banking – a risk-taking financial business – can operate without exposure to loss of at least some classes of lenders. Otherwise, bank debt is government debt. No private business can be allowed to gamble with taxpayers’ money in this way. That is evident.
The question, then, is not over the principle that lenders can face losses. It is about which of them should do so and to what extent. Apparently on the insistence of Nicos Anastasiades, the president of Cyprus, losses were to be imposed on deposits of less than €100,000, the upper limit for deposit insurance in the eurozone. The idea was to tax these smaller deposits at 6.75 per cent and the bigger ones at 9.9 per cent. Forgoing the former would have meant raising the rate for deposits above €100,000 to 15 per cent, to raise the required sum of €5.8 billion. A good thing, I would argue. But the Russian government does not agree. Nor does that of Cyprus.
A big question is why ordinary Cypriot taxpayers should rescue banks at all? With no bailout and full protection of deposits under €100,000, the tax on the remainder (after allowing for €1.4 billion from wiping out the junior creditors) would rise much further. Unjust? No. The only argument against this is that the government, as agent for taxpayers, created a dangerous financial system. So taxpayers must bear part of the cost.
Yet bail-ins create dangers. The actual package put forward was a balancing act between those frightened of creating further panic and others determined to address 'moral hazard'. The result could have been the worst of both worlds. The fact that depositors are on the hook may trigger flight elsewhere. At the same time, taxpayers still bear a big part of the costs of failures.
This leads me to some big worries.
The first concern is the deal itself. The decision to impose losses on insured deposits would indeed have been a big error. (Yes, it is a default, not a tax.) But the decision to bail in some deposits was not an error. However unpopular it may be, a resolution regime that makes this a reality is necessary, in Cyprus and elsewhere. Another concern is the blanket coverage of the tax, which would not have varied from bank to bank. This robs even big depositors of the incentive to monitor bank solvency.
The widest concern comes from The Banker's New Clothes, the book by Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute, which I reviewed earlier this week. Banks have so little loss-absorbing capacity that they stand permanently on the edge of disaster.
The case of Cyprus is an extreme example: beyond a small amount of equity stood only some €2.7 billion in unsecured bonds (€2.5 billion junior and €200 million senior) protecting €68 billion in deposits. Rightly or not, the other, including interbank loans were deemed untouchable. This structure gives the authorities not just in Cyprus, but virtually everywhere, a terrible dilemma: either rescue all institutions, thereby validating the riskiest business models and, at worst, putting the solvency of governments in danger; or refuse to rescue them and so risk causing a depression at home and panic abroad, particularly within the tightly integrated eurozone.
The eurozone must either make the industry far more robust, by hugely increasing equity capital, or consolidate fiscal capacity and tighten regulation, to ensure adequate eurozone-wide oversight and fiscal support. What is frightening is not that tiny Cyprus got into trouble, but that it is a source of wider danger. Banking is dangerous everywhere. But it still threatens the eurozone’s survival. This has to change – and very soon.
Copyright The Financial Times Limited 2013.