For a while, it seemed as if investors could get away with forgetting about the eurozone sovereign debt and banking crises, especially since last year's commitment by European Central Bank (ECB) President Mario Draghi to do whatever it takes to keep the euro intact. That commitment and subsequent asset purchase program seemed to quell market fears and shore up investor confidence. But the banking crisis in Cyprus forced investors to snap out of their euro complacency. While the Cypriot crisis and resolution have not led to broader contagion1
in the periphery, it has introduced a new — and perhaps concerning — precedent in the management of the ongoing eurozone crisis. In this quarterly commentary, we discuss the evolution of the banking crisis in Cyprus, the proposed resolution and what this could mean going forward.
Years in the making: the crisis in Cyprus
Before delving into an analysis of the Cypriot banking crisis, let's take a step back and look at the evolution of crisis management in the eurozone. During the past few years, eurozone economies facing sovereign debt and banking crises required bailouts by the so-called troika — comprising the European Union (EU), the International Monetary Fund (IMF) and the ECB — to provide emergency funds. In return, nations were required to begin austerity measures to reduce budget deficits, formalize a deleveraging plan for government debt levels and recapitalize their banking systems. This led to formal financial support measures such as the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM) and the Outright Monetary Transactions (OMT) facility.
In 2012, the ESM provided loans to the Spanish and Greek governments to recapitalize their banking systems rather than lend the funds directly to the banks, which added to sovereign government debt levels. As part of its bailout package, Greece completed the largest sovereign debt restructuring in history, in which Greek government bondholders exchanged their bonds for approximately 54% less debt in a voluntary exchange known as Private Sector Involvement (PSI).2
This leads us to the origins of the crisis in Cyprus, which was years in the making. Cyprus had grown its financial sector and its reputation as a financial center for several decades. It has a robust framework for the rule of law and a well-educated workforce. Importantly, it established double-taxation treaties with several countries, including Russia, stipulating that if profits are taxed at Cyprus' lower corporate tax rate, they are not taxed again in the other country. This resulted in an oversized banking system. While bank assets were small in absolute terms, their size as a proportion of the economy — nearly seven times gross domestic product (GDP)3 — was particularly significant (Figure 1).
So the country's banks attracted large nondomestic deposits (Figure 2), particularly from Russia, the proceeds of which were invested in Greek government bonds. According to the IMF, exposure of Cypriot banks to Greek government bonds and loans to Greek residents totaled 29 billion euro (160% of GDP).4 The write-down in Greek debt as a result of the PSI wiped out 4.5 billion to 5 billion euro in assets from Cypriot banks.5
Cyprus is more than a small, sun-soaked island tax haven strategically nestled in the eastern Mediterranean. To divorce it of political context is to lack critical understanding of the origins and drivers of the crisis. For centuries, Cyprus had been at the mercy of various conquering forces and became a pawn of regional superpowers. To some extent, Cyprus' political and economic policy choices could be understood within the prism of trying to secure its independence and sovereignty. In 1974, just 14 years after Cyprus established its independence, Turkey invaded the northern portion of the island and remained there even after a cease-fire, which resulted in a partition of the island and national pathos over the issue of reunification. This is significant because these events — not necessarily economic reasons — were among the driving forces behind the Cypriot decision to join the EU in 2004 and the eurozone shortly thereafter, along with strong political, social and business ties with Greece. The drive for reunification also led Cypriots to elect a communist president, Demetris Chrisofias, with the hope that he would mollify Turkey,5 which he did, but at the cost of devastating the government's public finances, a key driver in the subsequent banking crisis. In a bit of historical irony, Cyprus' attempt to secure political and economic independence and reunify has yet again placed the island at the mercy of its larger, stronger neighbors.
Protecting taxpayers: the Cypriot bail-in
On March 25, the troika agreed to a 10 billion euro bail-in deal of the most affected Cypriot banks. The bail-in is an unprecedented development in the ongoing eurozone crisis. As compared with a bailout, in which outside investors rescue a borrower by injecting money to help service a debt, a bail-in involves the restructuring of liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity. This approach aims to protect taxpayers from exposure to bank losses and reduce moral hazard. This seemed to make sense for Cyprus because from an economic perspective, given the size of its banking sector and the tattered condition of its public finances, the Cypriot economy wasn't large enough to bear the burden of bank recapitalization. Or, put more bluntly, it would have been politically impossible to push forward a plan which bailed out wealthy Russian depositors at the expense of German savers.
In the case of Greece and Portugal, bank bailouts were primarily financed by taxpayers. In the case of Cyprus, the aid package required that the creditor bear some of the burden of writing off the debt, so that neither the Cypriot government nor European taxpayers would inject any additional funds into the above-mentioned banks. Specifically, under the terms of the agreement with Cyprus, Laiki Bank, the country's second-largest, would be closed, and its bad loans separated into a "bad bank" and wound down over time. Laiki's insured depositors (under 100,000 euros) would be transferred to Bank of Cyprus. In turn, Bank of Cyprus would be restructured and recapitalized, with losses borne by uninsured depositors with accounts larger than 100,000 euros. Those deposits, estimated at 10 billion euros, would be frozen pending a "haircut" — returning only a portion of their deposits to depositors — to be determined by the bank's capitalization needs. In addition, as a precautionary step, capital controls were imposed to prevent a bank run.
Implications for the eurozone: a new precedent?
Thus far, the Cypriot bail-in hasn't rattled European markets or led to massive bank runs in other periphery economies, as was initially feared. The yield on the Spanish 10-year bond increased from 4.95% on March 25 to a peak of 5.07% on March 27 and has fallen steadily since then. This movement was mirrored by the yield on the Italian 10-year bond, which increased from 4.61% on March 25 to 4.77% on March 27, but it too has been steadily declining since then.
So what insights, if any, can be gleaned from the crisis in Cyprus and its resolution? Given the muted market reaction, we could be led to believe that Cyprus is too small and its circumstances too unique to draw any broader conclusions. However, while the Cypriot bail-in may or may not have constituted a watershed event, it serves an important precedent in that European taxpayers are no longer on the hook for every failed bank in the eurozone. The apparent success of the Cyprus bail-in has also moved the dial in the public discourse on the crisis. Jeroen Dijsselbloem, the Dutch head of the Eurogroup of finance ministers, acknowledged that it might serve as a template for future rescues, although he later publicly reversed his position. And while ECB President Draghi stated that Cyprus is not a template, he also stated that "a bail-in in itself is not a problem."8
Was Cyprus a one-off? A special case involving a unique country? Yes, probably, until the next one appears.
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