The Watcher Cat

The Watcher Cat

Monday, March 18, 2013

"Bailing In" the Blameless

Updated March 24, 2013

Let me preface his post with a word of caution; I am nobody's "go-to" guy on economic stories, and don't pretend to be. But watching the day's events in Cyprus is truly appalling. It's a skewed and distorted example of a principle found in the European Commission's June 2012 proposal for a framework to address credit failures, which created a "bail in" tool. As Graziella Marras summarizes:
The European Commission proposal would give resolution authorities the power to write down the claims of unsecured creditors of a failing bank and to convert debt claims into equity. Some liabilities would be excluded (e.g., secured liabilities, covered deposits and liabilities with a residual maturity of less than one month), but, crucially, the proposal would set minimum amounts of bail-in debt required for the balance sheet of each bank, which would be proportionate to the riskiness of the bank or the composition of its sources of funding — the European Commission mentions 10% of total liabilities as a possible level in the explanatory memorandum accompanying the directive. The European Commission even envisages cases where resolution authorities could use the “bail-in tool” and write down debt instruments without having exhausted shareholders’ claims.

This is a radical departure from the bailouts during the financial crisis, where only shareholders were wiped out. Some countries, such as Spain and the Netherlands, are anticipating EU resolution regulation. In the bailout of its savings banks (or cajas) in 2012, Spain decided to inflict losses also on preferred shareholders and unsecured bondholders, including many retail investors. In the recent nationalization of SNS REAAL in the Netherlands, unsecured bondholders were wiped out together with shareholders.
However, the European Commission proposal explicitly exempted from being drawn into "bail in" provisions "covered deposits," including those which fell under the 100,000 EU insurance limit (parallel to the FDIC guarantee).

Instead, in negotiating the Cyprus bailout, the EU, the European Bank, and the IMF have required as a cost of the bailout of Cypriot banks that some of the bailout funds be exacted from "the people who put money in Cypriot banks. Deposits of €100,000 or less would be subject to a 6.75 percent levy, and any deposits greater than that could be taxed at a rate of 9.9 percent." However, "the bailout deal [is] the first in the euro zone to include a “haircut” from bank depositors. The proposal is especially painful because Cypriots’ deposits are supposed to be insured by the government, meaning that depositors are guaranteed the right to withdraw whatever they put in. Obviously, that would no longer be possible if deposits are subject to a levy."

Now, Cyprus's need for a bailout is actually a spillover from the plunge into debt of its banks, itself a result of the crashing Greek economy; as the Washington Post explains, "Cyprus’s banks sustained a heavy hit when they were forced to write off large portions of their loans to Greek banks and holdings of Greek government bonds as part of a bailout of that country last year." So, because of the terms imposed in bailing out Greece by the same parties dictating the terms of the bailout of Cyprus, small depositors in Cyprus will be forced to underwrite the bailout. According to The Economist's Schumpeter blog, the inequity of the deal is clear: "there is no moral imperative for whacking Cypriot widows and leaving senior bank bondholders untouched, as appears to be the case here; or not imposing any losses on sovereign-debt investors in Cyprus; or protecting depositors in the Greek operations of Cypriot banks, as has also happened." Moreover, it's especially painful as Cyprus was, prior to the financial crisis, running surpluses. So this really represents an extreme case of moral hazard--the commercial investors in banks (bondholders) are being protected from the risks they assumed, while the small depositors who in good faith believed that their deposits were "safe in the bank" are having their property expropriated to recapitalize the banks themselves.

The Cypriots are understandably livid. As BBC Financial Editor Robert Peston explains:
Reform of how to mend broken banks, which has been negotiated globally and in Europe since the Crash of 2007-8, has been based on two central principles.

First, that the savings of ordinary people should be protected, up to a high threshold - or 100,000 euros in the European Union for example.

And that financial institutions which lend to banks by buying their bonds should incur losses when banks are bailed out: bondholders should, to use the jargon, be bailed in, as part of resolution plans.

The logic behind these tenets is simple: financial institutions ought to be sophisticated enough and informed enough to assess the risks of lending to a bank, and therefore deserve to be punished when their judgement is awry; most of the rest of us can't possibly know if our high street banks are making reckless gambles.

So what is seen by many as profoundly shocking about the terms of the rescue of Cyprus by the rest of the eurozone and the International Monetary Fund is that both of these principles have been broken.

Retail savers are being punished, by a levy of 6.75% on savings up to 100,000 euros.

And bondholders aren't being touched.
As Peston writes, leaving the equities aside--though, for me they are paramount here--"[a]part from anything else, in other eurozone countries where banks are weak, it licenses runs on those banks, as and when a bailout looms."

Indeed, it not only licenses runs on banks, it could be said to require them.

Update, 3/24/13: A last minute deal has been struck, which reportedly:
close down the island's second biggest bank and inflict huge losses on wealthy savers.

Russians would lose billions of euros under draconian terms which are aimed at preventing the Mediterranean tax haven becoming the first country forced out of the single currency.....

Savers with deposits of less than €100,000 (£85,000) would be spared, but it was thought there would be heavy losses inflicted on the deposits of the wealthy.

Laiki, or Cyprus Popular Bank, is to be closed, with its good assets transferred to Bank of Cyprus, the country's biggest bank, where savers would suffer big losses in return for equity shares. Those with more than €100,000 in Laiki would also be hit hard.

Negotiations got under way amid a hardening of the stance by the IMF and Germany, which insisted that depositors must take the hit for bailing out the eurozone's latest crisis economy.
So it goes.

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