The Cyprus bail-out

This septic isle

Being tough on bank creditors could prove costly for northern European taxpayers

The Economist

Mar 30th 2013 |From the print edition

THE second deal to bail out Cyprus was much better than the first. For one thing, there was actually a deal: with the €10 billion ($13 billion) loan the prospect of the euro zone’s first exit has receded. An agreement among euro-zone finance ministers to wind up Laiki Bank, Cyprus’s second-biggest bank, and restructure Bank of Cyprus, the largest lender on the island, undid the worst elements of the initial botched agreement. Savers with accounts below the €100,000 deposit-guarantee threshold will be spared. Losses will hit creditors of weak banks in line with the normal hierarchy: shareholders and junior bondholders first, followed by senior bondholders and uninsured depositors.

About time, many—especially the German voters who, it seems, figured large in the minds of the plan’s architects—will say. For far too long during this crisis banks on Europe’s periphery have got into trouble and been bailed out by northern European taxpayers. Jeroen Dijsselbloem, the Dutchman who heads the Eurogroup of finance ministers, made it clear on March 25th that the Cypriot deal represented a template: if banks fail, creditors can expect to pay the whole bill. The principle of moral hazard has supposedly been re-established.

The Nicosia neinfield

But at what cost? The fact that, within hours, Mr Dijsselbloem was back to calling Cyprus a one-off is a clue. His earlier comments had prompted a slide in the markets, as investors deduced that the deal had weakened the euro zone as a whole in three ways that German voters may come to rue.

First, Cyprus itself looks crushed. The collapse of its oversized, Russian-flavoured banking sector will cause a catastrophic economic slide—one which may need more cash.

Second, the deal allows Cyprus to use capital controls to stop deposits fleeing the banks when they reopen (on March 28th, with luck). The single currency is now not so single: a euro in a Cypriot account is not worth the same as a euro in Greece or Belgium. The euro zone says these controls are temporary, but Iceland’s are still in place over four years after they were imposed. A precedent for restricting the movement of euros is one that investors and depositors will not soon forget.

Third, the decision to punish large depositors will also weaken the euro zone. Whatever the justice of saving Russian money-launderers, the best way to protect European taxpayers from the cost of cleaning up banks is to give all short-term creditors reason to stay put. Hitting them will discourage them from putting money into weak banks in peripheral economies, and make it even harder to keep sick banks alive in crises. When a run starts it is rational for others, even insured depositors, to join. The euro area has €8 trillion of deposits and only €4.5 trillion of annual government revenues: governments could not guarantee all the deposits even if they wanted to.

Greater instability, coupled with rising resentment of creditor countries in a stagnant periphery, is a bad outcome for northern European taxpayers. It would have been better to put up a bit more money and push on with building a better banking system. That means extra capital: large European banks are building up buffers but are still €112 billion short of the new Basel 3 requirements. It also means putting less flighty creditors in the line of fire, by adopting an EU-wide resolution regime requiring banks to issue bonds that absorb losses before big depositors do. And only a full euro-zone banking union, including a fiscal backstop and a joint deposit-guarantee scheme, will break the link between weak banks and weak sovereigns. Europe, sadly, is behind in all these things.