Cyprus Finds Exciting New Way To Make Everyone Miserable

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Things in Cyprus: kinda bad. There are better places than here to read about it; I particularly recommend Joseph Cotterill here and here, pseudo-Paweł Morski here and here, Mohammed El-Erian here, the FT's coverage here and here, the Journal's round-up of analyst reaction here, etc.

The basic story is that Cyprus's government and banks are both massively overindebted and need a bailout, and the EU and IMF will provide a €10bn bailout, but they demanded that Cyprus chip in some €7bn, which it has decided to do by means of a tax on deposits in Cypriot banks of 6.75% for up to €100,000 and 9.9% above €100,000. (Is that rate on bigger deposits marginal or absolute? No one knows!) Those numbers are being renegotiated and may end up not being approved by Cyprus's parliament.

The various reasons to object to this boil down to its violations of absolute priority; the way things are supposed to work is more or less:

  • When a bank goes bad its equity holders lose,
  • If zeroing the equity holders doesn't cover the losses, then the bondholders lose,
  • If zeroing the bondholders doesn't cover the losses, then the depositors lose,
  • But even there deposits under €100,000 shouldn't lose, since they're government guaranteed under the EU deposit insurance scheme.

In Cyprus sort of the opposite happened: equity holders are being diluted but not confiscated,1 bondholders weren't touched (there are essentially no bonds),2 and depositors under €100,000 were haircut in order to limit the damage to depositors over €100,000. The reasoning for this is unclear; a leading theory is that softening the blow on over-€100,000 deposits was viewed as necessary to retain Cyprus's status as a haven for offshore deposits by tax-dodging Russian oligarchs. This is an odd theory; losing 9.9% of their money is no doubt a more pleasant proposition than losing 15% though it's not what you'd call absolutely pleasant and they don't seem particularly pleased with it. A competing theory is that Cyprus's president, who decided on the tax brackets, "only has rich friends."3

The counterarguments are numerous too and boil down to "it's the government, it can do what it wants, it can tax, this is a tax, whatever." Taxes can do whatever they want. There's a broad sense that this tax is unfair, but fairness is more of a nice-to-have than a must-have in taxation.

I think more and more these days about this great Interfluidity post about complexity in finance:

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. ... This is a core problem that finance in general and banks in particular have evolved to solve. A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs.

Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways. First and foremost, they offer an ironclad, moneyback guarantee. You can have your money back any time you want, on demand. At the first hint of a problem, you’ll be able to get out. They tell that to everyone, without blushing at all. Second, they point to all the other people standing in front of you to take the hit if anything goes wrong. It will be the bank shareholders, or it will be the government, or bondholders, the “bank holding company”, the “stabilization fund”, whatever. There are so many deep pockets guaranteeing our bank! There will always be someone out there to take the loss. We’re not sure exactly who, but it will not be you! They tell this to everyone as well. Without blushing.

Once I objected: well, no, complexity in finance is about intensive specifying of rules, not ambiguity. Laying out crystal-clear waterfalls is important. Finance people hate ambiguity; complexity is a way to avoid it.

That seems a little dumb now, no? There are crystal-clear rules about who loses in what order when a bank is insolvent, and who gets their deposits guaranteed, and those rules are ... well not violated, technically, this is after all a specific strange form of wealth tax, not a loss imposed on deposits, that would be illegal. But if they're your deposits it comes to the same thing. The rules exist, but they don't protect you. Because someone else - here mostly Cyprus government creditors though also big depositors - is being protected at your expense.

You can read in various places speculation and worry about how the Cyprus bail-in might spark bank runs in the rest of peripheral Europe / core Europe / the world / whatever; I don't especially counsel panic but then all my money is safe at JPMorgan Chase so who am I to say? Markets are off, anyway.

But you could put a positive spin on the precedent. Start with the negative: pseudo-Paweł Morski notes:

The hedge funds win again. A favourite trade for speculators has been Cypriot government debt. And it’s done very nicely. Mayfair sends its thanks. Update: This implies that you’re better off with your money in peripheral government debt than in a bank. That’s a message I personally would be very hesitant to send.

And:

Probably of more lasting importance is the latest bout of rule-changing by the authorities. Debt unwindings are generally well-defined in law. First equity, then sub debt, then deposits and senior bonds together, and all treated equally. Most of these principles have been tweaked over the last few years, but the tweaks are getting steadily more aggressive. ... While there’s clearly no point in market participants playing the shocked blushing virgin in the face of a situation where the consequences of following the legally-logical steps are socially unacceptable, the uncertainty generated creates costs too.

That seems right, but does it create benefits too? A series of rescues that respected a single rule of absolute priority, wiping out junior claims while leaving small depositors untouched, would send certain clear messages to people holding those junior claims. A series of rescues that concentrated the pain in only one of government debt (Greece), bank sub debt (Netherlands), or bank deposits (Cyprus), would send a clear message: get out of that asset class.

A series of rescues that inflicts pain in new and surprising ways each time sends ambiguous messages to the effect of "everything might be screwed but you can't really know that you'll be the guy who's screwed." Selling your peripheral government bonds to put your money in the bank, or taking your money out of the bank to buy bonds, could always turn out to be the wrong choice.4 Add in a dose of reassuring everyone all the time that their claims won't be touched, right up until they are,5 and you've got ... something? Maybe not a stable system, but one held in balance by all its conflicting instabilities?

A stupid idea whose time had come and The stupid idea, and the system [FTAV]
Cyprus: A Brutal Lesson in RealPolitik and Cyprus: What Were They Thinking? and some other notes [Paweł Morski]
Cyprus Prepares New Deposit-Tax Proposal [WSJ]
Cyprus Bailout Puts New Pressure on Europe’s Banks [DealBook]

1.Diluted because the depositors are getting shares. I see Bank of Cyprus shares trading at like €0.207 on Friday, for a market cap of ~€372mm, which wouldn't do much toward raising Cyprus's €7bn contribution, but still. I also see - as of a 9/30/2012 balance sheet, so whatever - book shareholders' equity of €2.3bn, so that's super.

2.Management compensation wasn't touched ... here you can read an article, dated Friday, about how the former CEO (until last July) of the Bank of Cyprus got a €2mm compensation payout this month under threat of litigation. I find this ... somewhat hard to believe?

3.Absolute priority as among banks and sovereigns is a trickier matter. Judging by people's gut reactions it seems like everyone thinks small depositors rank above government bondholders, morally, when the bank-and-sovereign complex is getting bailed in, but I'm not sure there's much rationale for that.

4.Moving your money to Germany: always the right choice? I dunno, some form of retroactive tax is imaginable there too.

5.In that regard note:

  • Cyprus's finance minister reassuring depositors by saying about the idea of a deposit haircut, two weeks ago, that "Really and categorically - and this doesn't only apply in the case of Cyprus but for the world over and the euro zone - there really couldn't be a more stupid idea," and
  • "Cyprus is an isolated event" - everybody, today.

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