Europe's 11th hour swing to salvation

Finally European policymakers have got the bailout equation right in Cyprus, removing some of the moral hazard tempting other faltering banking systems.

The European authorities might have initially managed their response to Cyprus’ banking crisis so clumsily that they risked triggering banking collapses at the periphery of the eurozone but they got to the right outcome in the end.

While the terms of the bailout that were struck overnight aren’t going to be welcomed by Cypriots, they do mark an important milestone in the eurozone’s haphazard efforts to stabilise its weaker banking systems, sending a very loud message to bondholders and uninsured depositors that they are at risk.

The chair of the group of eurozone finance ministers, Dutch Finance Minister Jeroen Dijsselbloem, got it right when he said that what the authorities had done was ‘’pushing back the risks’’ from taxpayers to shareholders and bondholders.

‘’We should aim at a situation where we will never need to even consider direct recapitalisation. If we have even more instruments in terms of bail-in and how far we can go on bail-in, the need for direct recap will become smaller and smaller,’’ he said.

Asked about the implications of the stand the authorities have made on Cyprus, Dijsselbloem said it meant that other governments with weak banking systems needed to deal with them before they got into trouble.

‘’Strengthen your banks, fix your balance sheets and realise that if a bank gets into trouble the response will no longer automatically be (that) we’ll come and take away your problems," he said.

The eurozone is, 4½ years after the financial crisis erupted, still studded with weak banks within weak economies because of a failure at the outset to address the lack of capital in the system.

Exacerbating the moral hazard within the system has been the history of taxpayer funded bailouts of banks in countries like Ireland and Spain, the existence of the European Stability Mechanism and its €700 billion fund for bailing out distressed governments and banks and European Central Bank president Mario Draghi’s commitment last year to do ‘’whatever it takes’’ to maintain eurozone stability.

Maybe tiny Cyprus, with a banking system seven or eight times the size of its economy and a reputation as a laundromat for Russian wealth, was an easy choice of target for a belated demonstration of the eurozone’s new-found willingness to make a stand. But it will send a chilling message to bondholders and unsecured depositors throughout Europe that the safety net beneath their exposures to undercapitalised banks has been withdrawn.

The initial attempt by the eurozone authorities to deal with Cyprus nearly destabilised the entire European banking system by including even insured deposits in the ‘’bail-in". That threatened to ignite runs of banks in those weak economies with weak banking systems, largely in southern Europe.

The structure of the final bailout leaves insured deposits (deposits of less than €10,000) unscathed but will mean heavy losses for shareholders, bondholders and uninsured deposits in a restructured Bank of Cyprus and in Cyprus’ second-largest bank, Laiki, which will be wound down.

Unsecured lenders and depositors and even senior lenders in the two Cypriot banks are going to experience losses, potentially quite heavy losses, which sends a very loud and useful message to the rest of Europe that they shouldn’t take the backstop of the ESM for granted – that they need to make their own assessment of the risks of lending to particular institutions.

There was, naturally, considerable volatility in European markets as they digested the implications of the new stand the authorities have made. It will make investors and depositors in Greek, Spanish and Italian banks more nervous and potentially raise their funding costs.

It will also, however, impose greater pressure on the banks and their governments to get their houses in order – even if that means pain for investors and depositors – rather than rely on an ECB bailout if the arithmetic gets too hard. That’s no bad thing.