Who Really Cares About Cyprus?

Cyprus has a population the size of Montana and an economy smaller than any U.S. state.¹ In the context of the European economy, Cyprus’ GDP of $23 billion is a rounding error—representing about 0.2% of total Eurozone GDP.² But its recent bailout created Eurozone-sized problems.

Cyprus roiled financial markets before reaching a last minute deal to bailout its indebted government and banking sector on March 25^th. Why did Cyprus cause such a stir? In a word: precedent. This was the first time depositors will take losses in a Eurozone bailout package—previously, only investors in the country’s banks and government were forced to take losses.³ And while the final deal penalized only uninsured depositors, the initial bailout deal would have included insured depositors as well. This matters because deposit insurance is essential for maintaining the health of banks in the Eurozone.

This paper explains the principles behind deposit insurance, why a guarantee isn’t always a guarantee, and why the recent Cypriot bailout saga could threaten its future in the Eurozone.

What Happens in Cyprus Stays in Cyprus…or Does It?

The final bailout deal reached on March 25th with the European Commission, the European Central Bank, and the International Monetary Fund winds down several of Cyprus’ largest banks. The condition of the €10 billion bailout is that shareholders and bondholders will take a hit, and depositors with accounts over the €100,000 deposit insurance limit in Cypriot banks will face significant losses.⁴

European leaders at first acquiesced to Cyprus’ initial proposal that insured depositors take losses because there were not enough investors in the banks to the foot the bill. Cyprus felt it had to use deposit accounts to raise the necessary funds required by European leaders as a condition of receiving the €10 billion bailout. However, insured depositors were spared in the final deal after the uproar caused by the initial proposal.

The implications of the Cyprus bailout cannot be separated from the notion of deposit insurance, and whether a promise is really a promise. Depositors with accounts over the €100,000 deposit insurance limit knew they did not have a government guarantee for the money in their accounts over that limit. But insured depositors had an explicit promise from their government.

The current philosophy reigning on both sides of the Atlantic Ocean is that shareholders and bondholders are making investments, and are not entitled to a risk-free product. They should be eligible to take losses in any bailout package—there are no guarantees for investing. Insured bank depositors, however, are entitled to a risk-free product.

Including insured depositors in any bailout package going forward would be a stark reversal of previous policy. Many worried that European leaders—including the European Central Bank—were sending a message to both insured and uninsured depositors in other Eurozone nations with shaky government finances and struggling banks. And if deposit insurance is not sacrosanct in the Eurozone, it could have unintended and potentially disastrous consequences for its banking system.

The role of deposit insurance

Many countries insure the deposit accounts—savings and checking accounts—of commercial banks up to a certain level. In the United States, the Federal Deposit Insurance Corporation (FDIC) insures deposit accounts up to $250,000.⁵ Bank runs—when depositors fear that their bank soon may become insolvent and all rush to get their money out at the same time—can cause significant damage to the economy. The purpose of deposit insurance is to prevent bank runs by assuring account holders that their savings are safe in banks, even if their bank goes under.

But, deposit insurance creates moral hazards. If depositors know their money is safe, they won’t monitor the lending practices of their bank. And if banks know that their funding is secure and guaranteed by the government, then they are more likely to make riskier loans. The riskier the loans a bank makes, the more likely it is to fail.

That’s where regulation comes in. U.S. policymakers and regulators limit the activities of commercial banks to curtail the riskiness of their lending practices. For example, commercial banks have to get a charter, maintain capital and liquidity standards, and disclose voluminous information to regulators.⁶

Additionally, each commercial bank with FDIC insurance is assessed a fee to maintain the FDIC’s Deposit Insurance Fund. This fund is used to make insured depositors whole when a bank with FDIC insurance fails. The idea is simple—commercial banks benefit from government provided insurance, and they should pay for the costs of cleaning up insured banks that fail. The Deposit Insurance Fund had $33 billion at the end of 2012.⁷

Commercial banks accept these fees as the price for deposit insurance. This does not mean that banking laws and regulations always constrain risky behavior or that fees are set properly to account for the level of risk posed by insured banks (See 2008). But the U.S. has the mechanisms in place for a well-functioning deposit insurance regime, including an independent agency to stand up for insured depositors. People left their money in banks during the financial crisis because they trusted that the FDIC would protect their deposits, and it delivered.

Does the Eurozone have deposit insurance?

Uh…yes and no.

Individual countries in the Eurozone have their own deposit insurance regimes, but the Eurozone doesn’t have one that covers banks in all 17 nations using the euro.

This is where the problem starts. The Eurozone doesn’t have a deposit insurance regime where each country pays the same costs for deposit insurance and operates under the same regulatory environment. A bank in Texas and a bank in Maine are essentially the same; a bank in France and a bank in Cyprus can be very different. In addition, there are no supranational mechanisms in place to unwind a failing bank and return depositor funds if the resources of an individual country prove inadequate.

What went wrong in Cyprus?

Cyprus has deposit insurance for accounts up to €100,000. But like the troubled U.S. insurer AIG, a country’s promise to insure funds is only as good as the country’s ability to pay account holders. Cyprus does not have the ability to pay account holders of failing banks because their banking sector is 6 times larger than the GDP of the entire country.

Insured Deposits - Cyprus v U.S.⁸

The “guarantee” of the Cypriot government to make depositors in its banks whole is, therefore, meaningless in times of stress. Trouble in the banking sector is the principle reason Cyprus sought a bailout package for both its own government bonds and for its banks.

Greece, Portugal, Ireland, and Spain have all received assistance for their banking sectors in the recent past. In these deals, European taxpayers picked up a large part of the tab, with investors also taking losses. Yet depositors—both insured and uninsured—were left alone.

However this time, Eurozone leaders consented when Cyprus initially proposed including both insured and uninsured Cypriot depositors in the loss-sharing burden. Part of the reason for going after these depositors is the special circumstances of Cyprus. Like some other Eurozone countries, Cyprus offered deposit insurance without meaningfully circumscribing the activities of banks to incentivize good behavior. They did not maintain an adequate deposit insurance fund. Their banks are considered notorious tax havens. For instance, about one-quarter of all deposits in Cypriot banks are held by Russians.⁹

Why does Cypriot deposit insurance matter for the Eurozone?

In a vacuum, it may make sense to ding the insured deposit accounts in Cyprus. Cypriot depositors should not expect other countries to bail them out due to the poor design of their deposit insurance regime.

But Cyprus doesn’t exist in a vacuum. Policies directed toward Cyprus can set precedents for other Eurozone countries. Are Eurozone leaders signaling that they won’t support the deposit insurance regimes of individual member countries in future deals?

The potential precedent being set in both the initial proposal and the final Cyprus bailout package was the reason many were concerned. Eurozone countries with healthier government finances and banking sectors—particularly Germany, who controls the purse strings of the Eurozone—are growing ever more resentful of providing taxpayer funds to bail out what they perceive as irresponsible behavior by struggling Eurozone countries and their banks.

For example, on March 25^th, Dutch Finance Minister Jeroen Dijsselbloem said that “the response will no longer automatically be that we’ll come and take away your problem,” and indicated that Cyprus could be used as a template for future bailouts.¹⁰ Markets immediately fell after his comments, and he was forced to issue a clarifying statement that Cyprus would not be used as a model.¹¹ If the March 25^th deal were to serve as a template for future deals, depositors with accounts over the €100,000 limit in Eurozone countries with precarious banking sectors would be forced to reevaluate the safety of their funds.

The fear was that European leaders were signaling that they were done providing significant assistance to struggling Eurozone countries—and that going forward, insured as well as uninsured depositors would have to contribute to the costs of any future bailout packages.

What are the potential consequences of the Cyprus bailout?

Cyprus isn’t the only Eurozone country who is highly indebted with weak banks that would struggle to maintain their deposit insurance regimes. (Cue Malta.)

Seeing the writing on the wall, depositors in struggling countries may eventually run to get their money out their banks if they think their accounts could be pared as part of a future bailout package that may become necessary.

The Financial Times’ Wolfgang Munchau makes the case that a bank run is a rational response in the current environment, using a theoretical Spanish depositor as an example:

“A Spanish saver in Bankia is confronted with the following questions: Does the balance sheet give a true and fair depiction of the risks? Is the Spanish government’s deposit insurance credible? Is Bankia safe now that it is partly nationalised?

My answers to these questions would be “no,” “no,” and “no”. In the absence of a European backstop (i.e. Eurozone-wide deposit insurance)…The Spanish state is too weak to provide sufficient guarantees to the banking system."¹²

This scenario is the real worry for the Eurozone. Depositors in peripheral Eurozone countries may look at what just happened in Cyprus and interpret it as a sign that they may have to contribute to any future assistance package. In turn, these depositors could decide to pull their money out of their banks. Once a bank run starts, it is hard to stop. And given current economic conditions, a bank run in a large country like Spain could strain the resources of the entire Eurozone.

In addition, the ad hoc nature of these bailouts affects the ability of banks in the Eurozone to raise funds in capital markets. When the rules regarding the treatment of bank investors seem arbitrary, these investors become less willing to put money in the banking sector, raising the cost of capital for banks. In addition, weaker Eurozone banks may struggle to get funding as investors look to put money into stronger and safer banks.

Conclusion

The potential for crisis has faded since the Cyprus deal was agreed to on March 25^th. There is no evidence that depositors in other Eurozone countries have started to flee their banks in response to the initial Cyprus bailout proposal. Financial markets have been calm since Cyprus reopened its banks on March 30^th. We don’t know what the next Eurozone bailout package will look like, if one is even needed.

But that’s part of the problem. Each time the banks in a Eurozone country get into serious trouble, the response is developed on the fly. There is no formal banking union among the 17 nations with structures in place to resolve bank failures and make insured depositors whole in a systematic way.

In this environment, precedents matter. With the Cyprus deal, Europe was resetting expectations about who will contribute to the orderly resolution of troubled banking sectors in Eurozone countries receiving assistance. It is unclear how insured depositors will be treated in any future Eurozone bailout package.

Without a Eurozone banking union, including a credible Eurozone-wide deposit insurance regime that has the same rules for all banks, Eurozone countries with indebted governments and precarious banking sectors will remain a dangerous structural weakness—subject to the whims of European leaders. Until the situation is corrected, the Eurozone will be susceptible to destabilizing bank runs, particularly in Southern Europe.