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Political
decision. Greece, Cyprus next Italy and Spain?
Let us be absolutely clear. This
was not a mistake due to ignorance or miscalculation. This was a deliberate
policy decision and not one based in economics. After all the size is rather
small, only 17billion. In other words, they chose the option to cut the
deposits not because they had no other option but because they wanted to pass a
political message. The small size of Cyprus is ideal for laboratory purposes
and for teaching others a lesson. The
question is, why throw kerosene to the Euro fire when things were seemingly
getting better? Why now? Italy does not have a government and this would
increase the tension. When the next country starts negotiation for a bailout
(Italy, Spain etc) what other trick would the Eurogroup invent? In Ireland they
used the pension fund money, in Greece they made a forced restructuring with
more than 75% losses, in Cyprus they are touching the retail deposits. What
would be the next solution for Spain and Italy? Could we have yet again another “one-off”
solution? Assets in these countries have become slightly riskier this morning. Who benefits from a possible
crisis escalation? Was it just the case of domestic political pressure in
Germany and Finland?
Market
Implications
It is not clear how the market
would react to the news. It is not the financial size of the problem but the
apparent paradigm shift in perceptions. Europe behaves like the worst third
world debt offender. This is the first Corralito
in the Eurozone! Market’s behavior in the short term depends on Cyprus reaction.
·
If
the Cypriot parliament approves the decision (2pm London time) then we only
have the long term repricing effects of a really bad European decision.
·
If
on the other hand the parliament fails, then we are escalating the Euro-crisis.
Could Cyprus threaten to leave the Eurozone? Could Eurogroup take back or at
least amend the decision?
o
It
seems that as of Sunday the government did not have the support of the
parliament, which is why they postponed the vote for Monday. It also helps to
see if the markets would help Cyprus’s case by causing chaos.
o
Can
Cyprus deal with the default without Eurozone’s help? Can they somehow cause a
default in their sovereign bonds and the bank without a social upheaval and a
forced Eurozone exit?
o
Financially
Cyprus could exit the Eurozone. The cost to the economy is not easily
calculated. Yes, initially there would be chaos but the fundamentals of the
economy and the future receipts from the proven oil and gas reserves would probably
remedy any ills.Could the re-introduction of the Cypriot pound be a solution?
o
The
main problem with the exit scenario in my view is geostrategic. Cyprus needs
Europe for political reasons. It is a divided island and needs the protection
and partnership with the EU. Thus, unless it can quickly re-align its alliances
the exit scenario is suicidal.
·
What
would be the reaction to other European countries that are in the process of
recapitalizing their banks? For example, in Greece this is an ongoing process.
Could Eurogroup threaten Greece with the same fate unless they adhere to the
MOU? What would this mean for the Greek deposits?
·
How
about Spain and Italy? What would happen to deposits if one day they announce
that they are starting negotiations with a view to activate the OMT program?
Could recapitalizing the banks through a portion of retail deposits be a
condition? The Pandora’s Box half opened when the Greek PSI forced losses on
bond holders. Now it is fully opened with retail depositors suffering losses.
·
The
IMF conducted a Debt Sustainability Analysis(DSA) that for sure did not take
into account the total destruction of the deposit base or the consequences that
such a decision may have upon the economy of Cyprus. Most DSA are fiction
anyway, but this one may be rendered useless much sooner. In other words more
measures maybe on the way for the Cypriots.
·
A
conspiracy theorist (which I am not) could argue that this may work in favor of
Germany and other AAA countries. This is how: as deposits flee the southern
countries they find their way in the northern countries. What this means is
that in a possible euro breakup the Target2 imbalances could be netted off with
the non-resident deposits in Germany (for example) thus minimizing the cost to
Germany. So by negating the deposit insurance guarantee they make sure that
Germany is going to lose less!
Cyprus
Deposits losers in Numbers. British Deposits.
Cypriot banks held at the end of
January 2013 around €68bln. Out of these 68bln, 42bln belong to domestic
depositors, 4.7bln to other European citizens (mainly Greeks) and the rest
20bln (4.5bln to other FI, 11.3 to corporates and 4.8 households) to non-EZ
citizens. This includes a GBP 1.2billion presumably owned by mostly British
citizens that could suffer a maximum of 120miilion losses. So a minimum of
4.8billon can be collected if we apply the 6.75% rate. Troika things it can
collect 5.8billion.
Most depositors in Cyprus were
caught by surprise. Some of the Greek money that fled to Cyprus went back to
Greece. It is estimated that out of the 5billion that left Greece for Cyprus
only 1.8billion had return to Athens. Thus, Greek depositors would suffer
200-300million losses.
Data from the bank of Cyprus also
show that at in January 2013 627million of deposits held by non-EU citizens
have fled. In other words there was no serious run on the Cypriot deposits.
This may change the next few days.
An
appalling decision. Deposits for Equity swap.
The best financial minds,
academics and technocrats wrestled with the question of how to recapitalize the
banks in Greece, Spain, Ireland, and other Eurozone countries and who is going
to pay for it. Euro area finance ministers and the IMF on the other hand had
the answer in front of them. They will implement a “debt for equity swap”
without the consent of the debt holders and instead of using normal Senior or Subordinated
debt they would use retail deposits. It is that simple. Why I did not think of
that!!
Lawyers and PhD students rejoice.
The EU has just created ample material for generations to study, litigate and
write about.
The branches of Cypriot banks in
Greece (with 18bln in deposits) are saved and would probably be given to a
Greek bank as a parting gift (Postal bank seems to be the winner).
Cyprus
financial position. Socializing the banks.
It is clear that Cyprus is facing
a rather big problem. The island’s banks had grown in size many times its GDP
(8 times). A milestone in this rather abnormal growth was the decision of the
Greek bank Marfin to acquire Laiki Bank of Cyprus and move its
operations and balance sheet to Cyprus from Greece. Marfin was a much bigger bank than Laiki and had the
majority of its risk exposure in Greek assets or Bonds. Other, more genuinely
Cypriot banks also had a significant exposure to Greek assets. With Greece
defaulting and the ongoing recession the losses on Cypriot banks multiplied. It
is also true that Cyprus experienced a real estate boom in the recent years and
that the previous administration inflated Cyprus debt. So, Cyprus found itself in
a similar position to that of Ireland a few years ago. In other words, they
were faced with the dilemma of either supporting and recapitalizing the banks
or oblivion. In both cases, anecdotal evidence suggests that the ECB issued an
ultimatum to the government. In the Irish case the state i.e. the taxpayers
took on the burden by directly guaranteeing the banks. In doing so they saved the senior bond
holders, mainly British and other European institutional bondholders to the
detriment of Irish pensioners and taxpayers.
In Cyprus on the other hand they
are doing the unthinkable. They are delving directly in the retail deposits. As
of this morning all deposits of less or equal than 100,000 are worth less or
equal 93,250 plus a piece of papers (share certificate) that no one as yet
knows how much is worth or what is written on it (it would be determined later
on by ministerial decision). For those “lucky” enough to have more than 100,000
the haircut is 9.99% instead of 6.75% plus the same piece of share certificate.
There are reports of course that the Cypriot government is renegotiating the
bands trying to get the 6.75% reduced to 3% and introducing a new 12,5% for
deposits of over 500k in order to convince MP to support the deal today.
Of course one would argue that
this is the perfect example of socializing the banks. The parties on the left
(like Die Linke in Germany and SYRIZA in Greece) should rejoice. Give the banks
back to the people. The problem is that no-one asked the people whether they
want to be forced shareholders of bankrupt banks or not.
Deposit
as Contingent Convertible Capital
For many-many years the capital
structure of a bank was stable. In case of default, the losses would eat away
first the equity capital, then Tier1 Hybrid capital, then the subordinated debt
and the senior debt and lastly the depositors. In recent years another
financial instrument was created, the Contingent Convertible capital or CoCo.
Very simply, this is a debt
instrument that converts into common equity if and when the bank is at risk
from losses or some financial ratio falls below a threshold. Many banks
including Barclays, Lloyds and others have issued such instruments. In this
way, senior debt holders and depositors are given an added protection should
things go wrong.
The decision by Eurogroup to
bail-in the depositors by forcing them to convert part of their money to equity
is unprecedented not only because it steels people’s deposits but because it
formally changes the hitherto position of depositors as senior creditors. It
treats retail deposits as Hybrid capital or CoCo. There is no default and no
official credit event as far as I understand. The EU has done something similar
when it exempted the ECΒ
from the Greek PSI thus creating a new class called “preferred investor” (and
not creditor since the ECB cannot be a creditor to a country).
Thus with one stroke the EU has
rearranged the capital order of a Bank. Instead of Common Equity, Subordinated
debt Senior Debt and deposits it reversed the order. This is by far the most
ominous sign for things to come.
Why
was it baptized “levy” and why the Deposit Guarantee Scheme failed?
EU directive 94/19/EC deals with
the Deposit Guarantee Schemes (DGS). Since 31 Dec 2010 the deposit insurance
was raised to €100,000. So why did the Eurogroup decision demands a 6.75% levy
for deposits of less than 100k. And why is it baptized as a “levy” when the
depositor gets swapped into equity? Perhaps the word levy is used to avoid the
legal complication of expropriation, especially by foreign depositors that
might breach Bilateral Investment Treaties that Cyprus has signed. As of 2011
there were 23 BIT but only 16 seemingly were ratified and Russia was not one of
them (data as of 2011). These now can sue the Cypriot government for inadequate
compensation.
With regards to why the DGS was
not activated the logic gets more convoluted. One can argue that since,
technically speaking the banks did not declare bankruptcy the DGS is not
activated. Needless to say that the DGS did not activate (as yet) precisely because
the deposits were forcefully converted to equity!!! For this argument to work,
senior bond holders must be left untouched which is absurd. So, not only you
convert deposits to equity but you also leave other less senior debt holders
untouched.
Here however, one can
mention Article 1.3 of EU directive 94/19/EC which defines:
‘unavailable
deposit’
shall mean a deposit that is due and payable but has not been paid by a credit
institution under the legal and contractual conditions applicable thereto, where
either: (i) the relevant competent authorities have determined that in their
view the credit institution concerned appears to be unable for the time being,
for reasons which are directly related to its financial circumstances, to repay
the deposit and to have no current prospect of being able to do so.
In other words, if the
(in)competent authorities determine that the banks appears to be unable
to repay the deposit then the DGS should be activated. This looks like to be
the case here, but the needs of the highest Public Interest need also to be
counted in.
Whatever the case, the
DGS is for all practical purposes dead. Anyone, who things that his money is
insured up to 100k is dreaming without the EU. The EU managed to insert doubts
in the bond market and now is doing the same in the deposits.
Highest Public Interest
Such extraordinary
measures can only be taken by a country under extreme circumstances. When
Greece unilaterally changed the terms of all bond contracts under Greek law,
they did it on the basis of article 9 of EU 593/2008. This allows a country to
suspend contractual law if it is in the highest public interest.
In the Cyprus case the
draft law mentions (own translation)
1. Since
there is a need to safeguard the financial stability and to avoid any
destabilizing factors that may seriously shake the whole of the Cypriot economy
with unforeseen socioeconomic consequences
2. And
since there is a need to secure the viability and the smooth functioning of the
financial institutions of the Republic and recognizing the inability of finding
funds for the recapitalization of these credit institutions that may cause
catastrophic consequences in the economy, the society and with serious
consequences in the total wealth
3. And
since the implementation of a levy on deposits is a necessary and timely source
of funds
We
decide…….
Although
they do not explicitly mention the words Public Interest they are trying to
describe it. In any case, converting
deposits to equity shares in failed banks is for sure in the interests of
someone but possibly not the depositor.
Conclusion
For the second time
Europe has shown that it is not mature enough to even keep the basic
fundamentals tenets of an advanced modern state. Banks are not allowed to
collapse and senior debt holders as yet are shielded from taking losses. On the
other hand violating the sanctity of retail deposits is ok. I wonder what the
Eurogroup would force upon the Italians and the Spanish. EU keeps surprising us
in a negative way.
