Cyprus Is A Lesson For U.S. Policy Makers: Too Big To Fail Is Not Inevitable

American financial regulators could take a lesson from their European counterparts. The recent EU bail-in/bailout of Cyprus, despite its dangers, shows that reducing moral hazard in the banking industry without provoking bank runs is possible.

As I write in Forbes, Cyprus is one of the most insolvent Euro member states.

Non-performing loans [in Cyprus] (NPLs) are 15.5 percent of gross loans, which is comparable to Italy (13 percent), Ireland (19 percent), and even Greece (21 percent). But the real problem is Cyprus’s staggering inability to absorb losses. NPLs account for an enormous 264 percent of tier 1 capital—a level so high that not even basket case Greece, at 217 percent, can compare.

Cyprus got this way because of the risky actions of its banks, which were heavily invested in Greek debt. Once Greece hit the wall, so did the Cypriot banking system.

Unlike larger countries like France, Italy, and Spain, the little Mediterranean island’s fate does not have great effects upon the Euro in purely economic terms. But its precedent matters because markets extrapolate future EU actions (for example, what the EU will do when larger economies come under financial scrutiny) from present ones. Accordingly, Cyprus represented a low-stakes means through which to change expectations for the future. In February, before the drama and media hype surrounding Cyprus began, I wrote about this opportunity in the Global Post.

Europe should think twice before simply handing out a bailout package equal to the entire Cypriot economy.

As Ireland’s current plight shows, burdening the taxpayers to save the banks and bondholders imposes unnecessary and long-lasting pain. Once the European Union provides the stabilization funding needed to prevent Cypriot contagion to the rest of the euro zone, the EU ought to set a new precedent going forward: that inefficiency has the freedom to fail.

In the final deal, Eurocrats decided against propping up inefficiency and insolvency like it had before. Those who took the risk of investing or leaving unsecured money in Cypriot banks are facing the consequences of their decisions. Bank recapitalization is occurring with private, not public, money. In the meantime, the European Central Bank is providing Emergency Liquidity Assistance to facilitate the uptick in withdrawals.

But the arrangement is not without risks, which I discuss in the EU Observer.

Foreign deposits comprise 37.5 percent of all deposits (compared to a Euro Area average of 22 percent), and international investors are unlikely to feel as secure putting their money in Cyprus as they once were. Cyprus’s enormous level of highly mobile foreign portfolio investment—totaling 122 percent of GDP—is unlikely to hang around for very long. Over time, foreign direct investment—currently at a large 89 percent of GDP—should also decrease. Add in the “temporary” capital controls that Eurocrats and Cypriot officials may institute at whim, and the little Mediterranean island no longer seems like such a financial paradise.

If economic conditions severely deteriorate, a second or even a third bailout or bank restructuring may be on the horizon. The cases of Greece, Ireland, and Portugal suggest that this is not the last we hear from Cyprus.

This also won’t be the last we hear about the threat of capital controls—yet another worry for investors with positions in other Euro Zone countries. Perversely, this could exacerbate instead of abate financial distress in countries that investors perceive may be next in line for a bail-in, as money preemptively flees before being locked down by controls.

Moreover, controls may not be as “temporary” as the Cyprus Finance Ministry and the European Commission claim. Iceland, which instituted supposedly temporary restrictions on currency convertibility in 2008, isn’t likely to phase out its controls until 2016, according to IMF projections.

Since the deal early last week, there have no destabilizing bank runs in Cyprus nor has anything of the sort occurred in other Euro member states.

Although the Cypriot government is receiving a bailout of roughly two-thirds its outstanding debt, the agreement is a welcome change in EU policy towards the financial industry.

Without creating mass panic, it seems that Brussels has begun chipping away at market expectations of endless private-sector bailouts.

U.S. regulators and politicians should look to Cyprus as an example of sensible financial policy.

Instead of instituting “Too Big To Fail” as a pillar of the U.S. financial industry through legislation such as Dodd-Frank, which labels certain large financial firms as “systemically important,” Washington should seek ways to reduce moral hazard. The best way to do that is by making policy more amenable to capitalism, in which the freedom to fail is just as important as the freedom to succeed.