“Horrifying.” “Dangerous.” “Shocking.” And yes, it is coming to a theater near you. Or so went the general reaction among the media and political punditry to a deposit levy central to the European Union’s Cypriot bank rescue arrangement. Yet, the deal, agreed on last weekend, marked a welcome shift by the EU toward a more realistic perspective on the euro crisis. On Tuesday, Cyprus’s parliament rejected the agreement in its current form. Despite the vote, the EU has made clear that it will not concede on the levy, which is expected to raise €5.8 billion ($7.46 billion). Now, both the EU and the little Mediterranean island find themselves in difficult positions.
Cyprus may come to regret this move for the lack of alternatives. Shifting costs onto Russian depositors, who account for the bulk of foreign depositors in Cyprus, is one option. But this risks Russia calling in a €2.5 billion ($3.2 billion) loan made to Cyprus in 2011—thereby widening the funding gap. Another option is to issue bonds tied to future revenues from development of a sub-Mediterranean natural gas field discovered in 2011, but this isn’t a credible solution because the field is in territory disputed by the island’s Turkish half and, putting aside these geopolitical concerns, Cyprus’s Energy Ministry doesn’t expect to begin exports until 2018.
Maybe the levy wasn’t such a bad deal in the first place. Data and economic reality show that a depositor haircut has been a long time coming. And it was certainly the best of Europe’s two other alternatives.
Consider the first scenario: The troika, made up of the International Monetary Fund (IMF), European Central Bank (ECB), and the European Commission, gives the Cypriot government the €17 billion ($21.9 billion) it had requested eight months ago to bail out its banks. This is the “nobody loses” option—that is, except for the Cypriot taxpayers who will face a crushing public debt load, high taxes, and a stagnant economy until the bailout loans are paid off. Add in the fact that 37.5 percent of deposits are foreign, compared to the 22 percent EU average, and asking Cypriots to be the sole cross-bearers seems even more unjust. Ireland tried a similar approach in 2008, guaranteeing depositors and bondholders only to renege on the latter during a 2010 troika rescue. The former “Celtic tiger” has been struggling to get out from under a whopping public debt load and painful austerity measures ever since.
Then there’s the second scenario: There is no bailout and depositors lose everything. Non-performing loans (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. The levies—6.75 percent on deposits under €100,000 ($128,659) and 9.9 on accounts over that amount, with equivalent bank equity shares for Cypriots—don’t seem so bad compared to the alternative of a full wipeout.
The first option reinforces the precedent of backing the stability of the common currency at any bailout cost but ignores the rise of German bailout fatigue in an election year, while the second option threatens to break that hard-fought stability apart. Neither is politically realistic.
While Cyprus’s original €17 billion request is pocket change for the €500 billion ($643.2 billion) European Stability Mechanism (ESM), reinforcing the precedent of full bailout is unaffordable. As with Greece, the small size of the Cypriot economy understates the risk it poses to the entire Euro Zone. That’s why getting Cyprus right is so important.
EU officials know that they cannot continue to fund bailout after bailout. Cyprus gives them the opportunity to begin to chip away at those expectations. Thus, when Spain, Italy, and France come a-knocking, the concept of depositors losing out won’t be such a shock—to either the markets or those countries’ citizens.
A deposit levy is a step in the right direction because it straddles the line between the moral hazard inherent in a full bailout and a catastrophic banking failure that destabilizes the euro when uncertainty turns to panic.
The deal was far from perfect. Instead of troika rescue funding propping up banks, it should go towards winding them down in an orderly liquidation. And senior bondholders ought to be taking losses (even if only symbolic ones) along with depositors. Yet it was still a welcome step back down to Earth. Finally, it seemed, Eurocrats were ready to reject the bailout panacea and accept the hard reality that everybody will lose money before the euro crisis is finished. Even as Cyprus refuses to face up to reality, the EU urgently needs to ditch the “nobody loses” myth before more Euro Zone member states line up at the bailout trough.