A blow to fractional-reserve banking

Cyprus shares some common features with Mauritius. It is an island economy, it has a lucrative offshore banking sector, its financial industry is dominated by two out of twenty-six banks, and they rely hugely on deposit financing with outsized liabilities in relation to the economy.
Cypriot banks are heavily exposed to Greek debt, they have largely financed real estate development, a sector deeply affected by the on-going financial crisis, and they are characterised by low levels of provisioning against bad debts. The offshore banking sector has underpinned the Cypriot economy for more than three decades and has thrived on its tax haven status. Economic diversification is limited, for Cyprus has no manufacturing base and is essentially a service economy with tourism as its second pillar.
The €10 billion bail-out package to Cyprus, of which 9 billion will come from the European Union (EU) and 1 billion from the International Monetary Fund (IMF), keeps Cyprus in the euro zone for the time being. It was initially intended to tax all depositors, insured or uninsured: 9.9 per cent on deposits of more than €100,000 (the upper limit for deposit insurance in the euro zone), and 6.75 per cent for the smaller depositors. But such a drastic measure, which appeared to protect big foreign depositors (mostly Russian) at the expense of small domestic savers, would have probably caused bank runs and a depression at home and panic in the euro zone.
Cyprus intimated that it would leave the euro zone. But under the pressure of the European Central Bank which threatened to cut off liquidity to the country, a new deal was reached on 25 March whereby the pain would affect much more intensely a smaller number of large depositors. Those holding up to €100,000 retain the full value of their deposits; a 40 per cent levy is applied on uninsured accounts exceeding €100,000; and Laiki Bank will be wound up with viable assets and insured deposits to be put into a “good bank” which will merge with Bank of Cyprus, and €4.2 billion of uninsured deposits to be placed in a “bad bank” and to be disposed of. The deal will restore the protection of guaranteed deposits, but the blanket coverage of the tax, which does not vary from bank to bank, deprives big depositors of the incentive to monitor bank solvency.
From bail-out to bail-in
The terms of the rescue plan were dictated by the German government following its objections to underwrite Cypriot banks’ foreign depositors through a bail-out with taxpayers’ money. Germany was adamant that uninsured depositors and other investors should bear a significant part of the financial burden.
This process for bank resolution is called bail-in: the bank is forced to recapitalise from within, using private capital from bondholders and uninsured creditors who thus become shareholders of the bank. A bail-in of depositors is thus a bank bail-out involving private investors. It is in line with an EU draft directive for a future resolution regime scheduled to be phased in from 2015. The bail-in process for bank resolution was not due to be implemented until 2018, which is why the markets were caught by surprise.
To cap it all, Dutch Finance Minister Jeroen Dijsselbloem, who heads the Eurogroup of finance ministers, declined to rule out taxes on depositors in other countries. Just after the Cyprus deal had been struck, he told Reuters and Financial Times that the rescue programme “represents a new template for resolving euro zone banking problems”. This remark rattled the markets, and European leaders had to downplay it. But the damage was done.
Although euro zone finance ministers qualify the Cyprus case as unique, the risk of contagion is present. The initial misstep to impose a levy on insured deposits under €100,000 has potential serious ramifications. Uninsured depositors across the euro zone will feel much less confident. Any future bank-related crisis will unfold more rapidly. In the event that a bank’s solvency is put into question, the chance of a run on bank deposits will be higher. What worries investors in banks of other vulnerable countries is that tiny Cyprus is a source of danger to the euro zone.
Right now, the introduction of capital controls in Cyprus is a dangerous precedent. It is the first time in the three-year-old European financial crisis that “temporary” restrictions on the movement of capital are imposed, in this case limits on the ability to withdraw money or to shift it between accounts or across borders. Based on the experience in Iceland, where capital controls have been maintained since 2008, one can anticipate that Cypriot authorities will prolong capital controls. Now, although the EU treaties allow restrictions on capital flows in exceptional circumstances, extended capital controls would violate a founding principle of EU membership and undermine the cornerstone of the monetary union: free movement of capital. As firms are demanding cash for goods and services, a long period of capital controls can worsen the problem of scarcity of cash. With the economy expected to suffer a hard recession, and the financial sector in turmoil, the risk of deposit flight will persist for a protracted period.
The bail-out of Cypriot “casino” banking (as Pierre Moscovici, the French finance minister, put it) will lead to a serious downsizing or even to the effective dismantling of the offshore banking system. Arrears are rising, business orders are drying up, and tourist arrivals from Russia may decline. The local economy is thus weakened, and annual GDP is forecast to shrink by 12.5 per cent before any hope of recovery. Under this macroeconomic scenario, further bail-out loans and debt restructuring may be inevitable.
Once the banks have been cleaned up, Cyprus will have to rebuild its economic model. In the hope that the island will explore recent discovery of gas fields in the Eastern Mediterranean, the banks have been promised to get offshore gas deposits. The problem is that Turkey has a claim on these gas fields, and its relations with the Greek Cypriot government have been belligerent since the Turkish invasion in 1974 (one third of the island went to Turkish Cypriots).
So it is not its moribund economy that will help Cyprus to pay back €13 billion: €10.6 billion will be generated from the levy on bank deposits, €1 billion from privatisation, €600 million from increases in taxes, and €400 million from sale of gold reserves. Hence one may ask whether Cyprus will exit the EU, which it joined in 2004, and abandon the euro, which it adopted in 2008. As EU and IMF will be in charge of the public finances for several years, this will fuel public debate on the merits of Cyprus membership in the single currency. The risk of a euro zone break-up is not tied solely to the situation in Greece.
Depositors on high alert
The Cyprus crisis sends several messages to euro zone members and to the world. First, creditor governments are willing to impose harsh conditions in return for financial assistance. Second, Germany is committed to limiting the exposure of German taxpayers to euro zone bail-outs, and there are doubts about how far it will be ready to share financial risks through the euro zone’s banking union. As a matter of fact, Germany has objected to the European Commission’s plans for a common bank resolution fund and for a single insurance scheme to cover bank deposits.
Third, political expediency is the order of the day in this on-going financial crisis: governments are flouting principles, making up rules and breaking them according to new events. At the start of this crisis, the US Treasury did not save Lehman Brothers and Bear Stearns, but did come to the rescue of Citigroup and Goldman Sachs. Today, deposits of Cypriot banks are treated more severely than deposits of Greek banks. Since rules change almost randomly, you never know what rules will apply to what banks, if and when.
The good news is that depositors did not start bank runs in Cyprus and in other parts of the euro zone, though there might have been large movements in deposits between banks elsewhere in southern Europe. The reason why bank runs are rare even in developed economies is that under the current fractional-reserve banking system, central banks can print money to bail out banks. The multi-trillion dollar bail-out of US and foreign banks by the Federal Reserve speaks volumes. Bail-outs not only reinforce the belief among depositors that troubled banks – especially the biggest – would always be bailed out, but they also give credence to the “too-big-to-fail doctrine” that the failure of only one large bank could smash the confidence in the entire banking system.
However, in the event that there are more failed banks that are not bailed out by taxpayers but bailed in by depositors and creditors, such banking crises will probably dilute people’s faith in government deposit insurance and thus shatter their confidence in fractional-reserve banking. This system can only exist if the depositors are totally sure that regardless of what happens to the bank entrusted with their deposits, they will always be able to withdraw them on demand and at par. Deposit insurance backed up by the central bank is seen as the guarantee that brings about such confidence. In effect, depositors act as if one hundred per cent of their money were always “in the bank” thanks to the power of central banks to create money out of thin air.
The bad news for depositors is that the principle of limiting taxpayers’ direct exposure to bank bail-outs is drawing widespread public support. The real question is when will a bank in trouble be protected by newly printed money, and when will uninsured depositors be forced to shoulder part of the cost of a bail-out. The second option is gaining credibility on account of the slow collapse of the fractional-reserve banking system, from the implosion of the savings-and-loan industry in the United States in the late 1980s, through currency crises in East Asia, Russia, Mexico and Argentina in the 1990s, and to the financial meltdown of 2008 with its never-ending global consequences. Fractional-reserve banking is dangerous everywhere, and it threatens the survival of the euro zone.
Shifting the sources of funds
For sure, the Cyprus crisis strikes a blow to fractional-reserve banking. The consequences of the Cyprus bail-out could be that depositors, both insured and uninsured, throughout the world would become much more cautious in dealing with banks. They would run at the smallest hint of banking instability. To prepare for such an eventuality, banks would gradually shift their sources of funds from deposit to equity capital and bond financing.
The problem with deposit financing (banks finance loans with demand deposits) is the mismatch between the maturities of assets and liabilities. It will be reduced if equity, bonds and time deposits (that cannot be redeemed before maturity) become the main sources of finance for bank loans and investments. Demand deposits could then serve for providing payments systems like ATMs and debit cards.
In Mauritius, all of the twenty-one institutions licensed to carry banking business engage almost exclusively in deposit financing. As at end December 2012, bank deposits account for 72 per cent of total liabilities, which stood at 968 billion rupees, representing 260 per cent of GDP. It is unthinkable that all depositors can be covered by an explicit deposit insurance scheme that the Bank of Mauritius is pressing the Ministry of Finance to introduce. To some extent, a limited public guarantee for small depositors would be acceptable.
Meanwhile, savers in Mauritius believe that the authorities offer them an implicit state guarantee. The soundness of public finances reinforces this confidence in the banking system. Another factor is that savers constitute a significant part of the rural electorate. That is why there has been no bank run yet in Paradise Island. The other side of the coin is that banks tend to indulge in moral hazard and in adverse selection, to accumulate bad debts, to reschedule non-performing accounts and to disguise soft defaults as loan restructuring. It is to be hoped that, after leaving all profits in private hands, the government will not be called on, one day, to socialise all the banks’ losses.

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