Sowing the Wind

By Frances Coppola, Proprietor, Coppola Comment

The terms of Cyprus’s bank bailout have shocked the world. For the first time, small bank depositors will take a hit.

Small depositors have long been regarded as sacrosanct. Although in theory they rank alongside bondholders and large depositors in the queue for funds, in practice they have always been protected – usually by taxpayers.  There is a widespread belief that because small deposits are insured in nearly every developed nation, therefore they should not take losses when banks are bailed out instead of being allowed to fail. Depositors losing money when banks are kept afloat, when they would have escaped unscathed if the banks failed, seems both unfair and illogical.

Hence the reason for the “shock and awe” response to the Cyprus bailout terms. A 6.75% one-off “stability levy” will be imposed on deposits covered by deposit insurance (under 100,000 Euros). The levy on larger deposits will be 9.99% – not a great difference, really, and much less than might have been expected: after all, depositors could lose 100% of deposit value above 100,000 Euros. Additionally, there will be higher withholding taxes on interest. These penalties will be applied to all deposits, including those in well-managed banks that don’t require bailout.

The description of this as a “tax” or levy is a bit of a fudge. Under what type of taxation scheme are people provided with shares to compensate them for the taxes they have paid? But that is what is happening here. Depositors will be provided with bank shares to the value of their losses. They are being “bailed in” in the same way as junior bond holders: a percentage of their deposits are being converted to equity. The money taken from the depositors will go to the sovereign to compensate it for the cost of bailing out the banks. At the end of the process, the sovereign will be left with a manageable amount of debt, and the banks will be owned by their depositors and junior bondholders. In effect they will have become mutuals.

When I explain it like that, it doesn’t sound so bad, does it? The problem for depositors is twofold, really:

  • their liquid assets (cash deposits) will have been replaced with illiquid ones (shares in banks that currently have little market value)
  • they are forced to take the risk that the future value of those banks will not compensate them for the money surrendered to the sovereign.

So depositors have an immediate liquidity problem, and the possibility of future real losses. They are not suffering a real immediate loss of capital at all. The sovereign is providing them with shares to the value of their losses. Yes, I know those shares look like duds, but there is no market for them so it is impossible to obtain a real market price. The sovereign is valuing the shares as it sees fit. It remains to be seen whether the sovereign’s valuation is correct. I have considerable doubts about this, but that is for reasons that have nothing to do with the current bailout and everything to do with the real economic issues in Cyprus and the utterly inept and counterproductive measures being taken to deal with them.

Plenty of people have questioned why small depositors had to be hit at all. The German financial minister, Wolfgang Schäuble, who appears to have masterminded the bailout plan, wanted large depositors to take a much larger hit so that small depositors could be protected. The IMF took a similar view. It seems that the Cypriot government did not agree. There is considerable speculation as to why the Cypriot government preferred to see small depositors hit. To me it seems most likely that it has to do with the Cypriot government’s wish to avoid upsetting Russia, given Nicosia’s hope that Russia will contribute to the bailout by softening the terms of its existing sovereign loan, and the considerable amount of money (some of it undoubtedly dirty) from Russian oligarchs that is held in Cypriot banks. But it is also possible that Nicosia is still hoping to maintain its foothold in the international tax haven network. Even with the 2.5% increase imposed as part of this bailout, corporation tax is a very competitive 12.5%, and the Cypriot government has encouraged growth of the financial sector by attracting deposits from overseas investors.  Frankly I think this is pie in the sky. A 10% loss may be all in a day’s work for corrupt depositors, but that doesn’t mean they will continue to deposit funds in a country that imposes losses like that when there are others that don’t. The large depositor haircut is a mortal blow to Cyprus’s ambitions to be an international financial centre – and that has serious implications for its economy.

Cyprus’s economy is dwarfed by its financial sector, whose total assets are 8 times its GDP. It’s uncannily like Ireland without the property bubble but with a much larger neighbour and trading partner in a horrible mess. And like Ireland, the sovereign cannot afford to bail out its banks. A taxpayer bailout like that done in Ireland would leave the sovereign with estimated debt of 145% of GDP. The IMF considers this unsustainable, and under its own rules would therefore be unable to contribute to the bailout fund. As the Eurogroup is expecting the IMF to contribute, clearly a taxpayer bailout of Cyprus banks would be out of the question, unless it was immediately followed by Greek-style PSI restructuring of sovereign debt. No-one wants to go there….

Except that they will go there, eventually. Although I have explained above why this is perhaps not such a terrible deal for depositors as it seems, that is not how they will see it. The run on Cypriot banks started as soon as the deal was made public. Cyprus was forced to introduce temporary restrictions on the movement of capital to prevent depositors removing their funds to avoid the levy. And although this choked off an immediate acute bank run prior to the levy being imposed, I do not think depositors will want to keep funds in banks any more. After all, it’s not very long since the Cypriot President announced that there would be no deposit haircut… if the Government can break that promise, why should depositors believe the description of this levy as a “one-off”?  Large depositors will eschew Cyprus in favour of non-Eurozone countries such as Latvia. Small depositors will withdraw funds in cash and stuff their mattresses, or they might buy gold.  In fact there has been a slow run on Cypriot banks for some time now, as international depositors withdrew funds due to bailout fears: I expect this run to increase to a flood once banks re-open after the bank holiday.

The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout. “Deep recession” is already forecast for Cyprus. A major bank run will be economically catastrophic. And the effect of that economic disaster will be to increase both the fiscal deficit and the public debt as a proportion of GDP. After all, even if the government doesn’t increase borrowing, a collapse in GDP immediately raises the debt burden to unsustainable proportions, spooking investors and causing unaffordable rises in yields on sovereign debt.

Cypriot banks may or may not become insolvent. They will become completely dependent on central bank funding, of course, just like their Greek counterparts. But a second bank bailout is not a complete certainty. What in my view is a racing certainty is a SOVEREIGN bailout due to GDP collapse some time in the next two years. This bailout may have averted the immediate risk of disorderly default and Euro exit, but economically it is completely insane. And it is dangerous, not just for Cyprus but for other countries too.

For the fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too. Yes, Olli Rehn says they have no current plans to do so, and insists that the Cyprus bailout is unique. But haven’t we heard this before? Wasn’t the Greek bailout “unique”, and the Irish bailout, and the Portuguese bailout, and the Spanish bailout? It is only “unique” until the next domino falls. I would not be surprised now to see bank runs across the entire Eurozone periphery, and perhaps in other EU countries too.

They have sown the wind.

UPDATE: It appears that Cyprus came very close to actual default. This tweet from Yiannis Mouzakis shows that the ECB was preparing for collapse of Cyprus’s two main banks:

“Local reports, the blackmail to  peaked at 3.00am on Sat when Asmussen called Draghi, said ECB to prep for collapse of two Cyp banks”

The timing of this is exquisite and it is hard not to conclude, as Mouzakis does, that it was done to put pressure on the Cypriot government in order to obtain a deal at any price, regardless of the consequences for the Cypriot economy and for its people. If that is true then it exposes the European Union for what it is rapidly becoming – a nascent totalitarian state.

UPDATE 2 – The FT confirms the ECB’s role in forcing through the deal. It says the ECB threatened to stop providing liquidity to Laiki, Cyprus’s second-biggest bank, which would have caused an immediate disorderly collapse. I have written previously about the ECB’sdisgraceful behaviour. This is the worst example yet.


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Frances Coppola

Frances Coppola

In a past life I worked for I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management

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  • Kafkaesque

    The exact same Bible quote appears in today’s NYT crossword puzzle – coincidence? Just curious; it’s weird for me that I had never heard the line and now I’ve heard it twice in one day.

  • MFH

    good post. Thanks. How dangerous is this for the rest of Europe? Is this really as bad as many presume? Could there be some type of domino effect here?

  • SS

    How can you have money in a Greek bank and not be totally terrified that you’ll wake up one morning to a 10% loss through this “tax”? How does this not result in massive bank runs across the region?

  • hangemhi

    So is this a black swan, or a white one? Either way, we’re likely to finally get that correction everyone has been waiting for.

  • MFH

    I don’t think this actually improves matters. If you bank in Portugal or Greece you can’t be willing to leave your money in this totalitarian German owned banking system.

  • Very Serious Sam

    Probably this new approach is a result of the (so far kept confidential) findings of the EZB about the median and average wealth distribution in Europe.

    Since it is, understandably so, hard to accept for, say, the people of Malta to pay for, say, Cypriots who are wealthier.

    Same applies for Germans vs. Italians or French. This bail-in of Cypriot depositors could very well be the blueprint for the next rounds of Eurozone rescue-attempts.

    Anyway, What the Cardinals of the European Currency Union should have done instead from the very beginning of this whole bailoutomania, starting with Ireland, is to insist that in every case, 1st the senior bond/equityholders and employees of the banks, 2nd the depositors, and only as last resort the taxpayers of other nations are to pay for the clean-up of the mess which the financial sectors have created.

  • Indignado

    This is a very interesting development indeed and I think points out some serious issues regarding our monetary system here in Europe. It seems that this is going to have serious ramifications on the notion of “inside money” being a viable system for the periphery countries of the EU. As the article points out, we are already being taxed exorbitantly in the name of austerity; now they are unilaterally “levying” deposit accounts?

    The Troika has said this is one off event, and is due to the special nature of the Cypress banking system. Living here in Spain and knowing the precarious situation of the banking system here, I am concerned about what steps will be taken for future bank bailout needs here. With 95% inside money to 5% outside money as pointed out in an earlier post by Cullen, I certainly feel safer holding on to antiquated cash. And BTW,,, thank god that cash has not been rendered out of existence, because we would indeed then be stuck in monetary prison if our checking accounts were only full of electronic credits. I guess this is where theory hits the road, or the brick wall if you like.

    I guess the bottom line is exactly this. When you have a banking system that has serious solvency issues, then cash is king. And the troika has gone a long way in making this crystal clear to the depositors of the periphery euro zone countries; a job well done indeed.

  • Juhani Huopainen
  • SS

    Now that I think about it, I don’t even think this matters half as much as some people think.

  • Frances Coppola

    Of course, if you live in a country which has no central bank, cannot print its own money and relies on a (not particularly friendly) external source for supplies of cash, then cash may be a rather weak king.

  • Gary-uk

    Idiot savers, they are just hoarding their savings. They deserve this loss for not investing their money in local start up businesses.

    Well done the ECB, perhaps savers need to wake up to saving in a zone where the state cannot print to guarantee anything. Great news for the Euro in the long run, and of course for gold.

  • Andrew P

    “Depositors losing money when banks are kept afloat, when they would have escaped unscathed if the banks failed, seems both unfair and illogical.”

    Wrong. The “insured deposits” in Cyprus banks are e 30 billion, which is a sum far beyond that little state’s ability to pay. Cyprus banks rely mostly on deposits for funding as well, as bonds amount to only e 2 B. If nature was allowed to take its course, the depositors would have lost almost everything. The only options to prevent this were a generous EU bailout and a less generous one.

  • Jos Evans

    Why not?

  • Jos Evans

    Hi Indignado,

    What are you planning to do with your savings in light of this? Given you live in Spain I am curious to find out whether this is likely to make you withdraw your funds from banks?

  • Stephen

    Pretty awful piece.
    First,strategically Europe Cyprus simialr to most recent involvement looking for a contribution.No change there.Tactically it could not get same via negotiating with bondholders because Cyprus doesn’t have many.It’s a very heavy cash economy which leaves limited options for getting a contribution. That Cypriot politicans opted to distribute such a ‘levy’ without aking it progressive is pretty stupid,but also in line with what I know of Cypriot politicinas.
    Certaily,allowing bankruptcy doesn’t protect the depositors ether ina comprehensive sense becasy Cyprus does not have the resources to immediately make good on depositor compensation in the face of a caused by bank failure.
    There were no easy options and still are not although I would expect current talks in Cyprus will amend yesterdays proposals to make them more equitable to cypriot depositors.
    Either way they’re done now to a certain extent.As an offshore financial base they have just lost credibility one would think although I said from the moment Greec got into trouble that this would be the enxt issue in that part of the world. Greece and Cyprus are joined at the hip.

  • jt26

    I don’t think this will amount to much. The Cypriot banks aren’t systematically important, and after IceSave, you’d think any one stupid enough to buy large *uninsured* deposits would be real idiots; even with “insured” deposits they must know the government could not back the insurance (you see this occasionally in some countries, where credit unions are backed by state-level or private insurance scheme and a quick calculation shows that reserves are inadequate).

  • jt26

    BTW a 10% levy for global tax avoidance on the cash amount is a pretty good deal; the Russians shouldn’t complain. But, I do feel sorry for Joe Citizen Cypriot who has been lied to by their government, but maybe they benefited from the Cypriot tax haven status so now the chickens are coming home to roost.


    I just came back from lunch and on the national lunch time news they are polling Spaniards to ask if they are going to withdraw money from the banks. I don´t think that is very responsible, but not surprising given these new developments.

    I am lucky in that I am a Spanish resident, but not a citizen. I have more options to transfer funds out of the country and have been actively pursuing this strategy since the crisis began. Many of my friends here do not have this option, and there is great distrust in our banking system. I am trying to see if I can´t get a good deal on an apartment here. As I said before, cash is king in this regard.

    Credit is incredibly tight and you can get very good deals now on properties since the banks are hell bent on not getting any more mortgages on their books. Since there is virtually no credit, asset prices are dropping and those that have cash are taking advantage. I guess we call that deflation in motion and we are living it first hand here in Spain.


    Andrew P. What analysis would you make regarding the Spanish banking system.?

  • Hans

    MFH, why are the Krauts to blame ?

  • Hans

    Ms Coppola, a delightful welcome to PC…!

    Ask yourself why these nations joined the Euroland Federation ? Did they have something to gain ?


    I don´t think that is a fair response. Being punished for investing for ones future in a savings account or CD is far from idiotic. It is (or at least used to be) a conservative way to protect ones assets.

    I would agree with you that gold is also a good hedge for some sort of new financial crisis, but you can´t criticize people for keeping a savings account. (well, at least you couldn´t until this past Friday :-))


    My argument is that when you are in full blown deflation, as we are here in Spain, then cash is indeed king. If the banks aren´t loaning, and npls are rising and asset values are plummeting (particularly real-estate) then having cash is a very good place to be.

  • Johnny Evers

    White swan. No surprise the banks are involvent. Their only assets are debt.


    I don´t think this ends with Cyprus and that is where the systemic risk lies, right? What advice would you give today to a holder of a Spanish bank account given what happened in Cyprus? In particular, taking into consideration the worsening conditions of our banks here and spiking NPLs, what would you advise depositors? As you argue above, “even with insured deposits they must know the government could not back the insurance”… likewise Spain can not possibly back it´s obligations to 100% cover of all checking deposits of less than 100,000 euros if there is a run on the bank?

  • Stephen

    “Russia’s number two bank VTB – a state-owned institution – alone had $13.5bn (£8.9bn) resting in Cyprus through a subsidiary and was due to lose a tenth of that amount, news agency AFP reported”

    You were saying ;)

  • hangemhi

    A banking problem is definitely not a black swan – but this specific one???? Going after sub-$100k depositors and its meaning to depositors around the eurozone?

  • jt26

    The biggest risk with Spain is not Cyprus-like, but rather that it will leave the Euro (and your deposits will suddenly be redenominated in Reals). I would weigh the risk that at some point the Spanish social/political winds will change and they realize leaving the Euro will be for the best. Although the Spanish has shown themselves to be able to tolerate a lot of pain (Franco, 90’s recession), even they have their limits. I’m pretty sure German banks are preparing for the inevitable writedown (this resolution is a typical pattern in third world countries; IMF comes in and papers everything over for 5-10 years and then default, giving players some time to get ready). BTW, Spain’s banks don’t have assets of 900% of GDP.

  • Johnny Evers

    From what I’ve read of Taleb, he would probably say that nothing resulting from the ongoing bank crisis would be a surprise.

  • jt26

    BTW I think “systemic risk” gets overplayed like “black swans” and “money printing”. I’ll believe Cypriot systemic risk when FT reports:
    (a) Cypriot banks is an unpublished primary dealer to the Fed
    (b) Cypriot banks hold derivative notionals on $100T
    (c) Cypriot banks are the sole market maker for Euro trade financing

  • Frances Coppola

    Why, thank you Hans!

    Why, thank you Hans!

    They believed they did. And in many ways they still do stand to benefit. We tend to forget how prosperity improves when nations can trade freely with each other without fear of war. Elimination of war was the founding principle of the European Union. And if war can continue to be avoided in Europe – which after all has a very bloodstained history – then everyone stands to benefit, even with all the financial and economic problems.

  • Frances Coppola

    You’ve exposed the sham that is the EU deposit insurance scheme. The terms of the scheme are mandated by EU directive, but the funding of it is the responsibility of member states. Cyprus had no choice but to maintain the EU standard deposit insurance scheme even though it could not afford it. I was explaining the insurance implications in the way that depositors would see them. On paper they stand to lose less if banks fail. But that would require a sovereign bailout – so they would still end up paying anyway, through austerity and tax rises.

  • Frances Coppola

    I think you, like many, are underestimating Cyprus’s strategic importance. It may not be important to the US, or even to the EU, but it certainly is to Russia.

  • Frances Coppola

    You have more faith in AIG than FDIC? Wow.

  • micro2macro

    Some thoughts…….

    I suspect that some Germans are maybe getting worried about some strategic issues. The reason being that there are some of the other smaller European banks in Ireland (where I am personally invested) – for example,where the buyout of about 40% of the Bank of Ireland, the largest non private bank in Ireland by 3 non European funds including Prem Watsa and W L Ross and Greece where they are now taking to foreign investors (read big US hedge funds/Watsa and Ross has visited there lately) to support them with large stakes that will give these hedge funds a large amount of influence.

    Imagine being a US hedge fund and getting the chance to own a bank in Ireland or Greece or Spain. Imagine the influence you could have? You get to choose who to lend to. And then you start to lend to your mates in the US and not to the locals. Suddenly Cyprus is the 51st state.

    These funds know that with a bit of tinkering, deregulation and privatisation (which they then will fund since they own part of the banks) the places will improve and when they do, they will stand to make an absolute bucketload. They watched Buffett stand on the throat of Bank of America in the GFC and extract some unbelievable terms in return for some money but also for a public vote of confidence.

    I think the some of the smart ones saw this and started to think that they could do the same thing, not in the US which is too big for them, but they could hit the peripheries in Europe and since they are not German they are welcomed as a bulwark against the Germans.

    Cyprus wanted 13 billion. That is loose change for Gates, Buffett and other billionaires. The European community don’t understand how small these places are and how rich the US billionaires are.

    Ultimately the state is going to have to decide how far they are prepared to let capital “in” to areas where they were hitherto seen as the only savior. Think about how hard it is for the sovereign state reign in the free flow of global capital. They spent the last 30 years preaching the benefits of globalisation, and now suddenly they are not interested anymore. If the Cypriots want US money then why should the Germans be allowed to block them?

    Suddenly the bailout of AIG and GM and other sectors doesn’t look so bad. So Bush and Obama bailed out GM and AIG but those companies still hold influence. So besides all the criticism regarding using public money, the USA still maintains its global hegemony, these companies are profitable for the first time in a long time, have a low US dollar to help them compete in the global markets. Personally I think many forget the US is a giant amongst pygmies. Imagine what would have happened if the US had let all those sovereign wealth funds in to control their global giants? If the Germans and French don’t understand this, they will wake up and see that Europe is not theirs anymore but they are now the 51st state.

    I note that Stratfor has a commentary out which I think supports some of the above…


  • Frances Coppola

    You haven’t said anything I didn’t say in the piece. My spelling’s better, though.

  • Tom Brown

    Ha! :)