The EUR 10 billion bailout of tiny Cyprus should have been a global non-event. Instead, ineptitude on the part of the European Central Bank (ECB), the European Commission, the International Monetary Fund (IMF), and the Cyprus authorities has threatened the stability of Europe's banking system.
The original conditions of the proposed bailout required a "one-time" confiscation of 6.75% of all deposits up to EUR 100,000 and 9.9% of all deposits above EUR 100,000. There are ongoing discussions to adjust these percentages and make them more progressive. Nevertheless, the final percentages are irrelevant; the damage has already been done.
Banks are highly leveraged institutions and their very existence requires unwavering confidence in the banking system and in the safety of all deposits. Even if all bank loans and investments were sound, all depositors' funds would still not be available for immediate withdrawal. Instead, banks lend those funds to business and to individuals (and make other investments) in an attempt to earn a reasonable rate of return on their assets.
This creates a mismatch between bank assets (loans and investments) and bank liabilities (deposits). Technically, deposits may be withdrawn immediately, but it is not possible for levered financial institutions to liquidate loans and investments to fund all deposits. This is not normally a problem because depositors typically make small, predictable, transactional withdrawals to meet their regular spending needs - unless they lose confidence in the safety of their deposits. Then all bets are off.
Once confidence is lost, bank runs are the logical and inevitable result. Consequently, the guiding purpose of banking regulation is to protect the integrity of the banking system and to safeguard the assets of depositors.
Instead of protecting the depositors, European authorities decided to confiscate a significant portion of their funds. This is unprecedented and inexplicable. It violates the basic tenet that has been in place since the great depression. This one simple plan has forever threatened the integrity and stability of Europe's banking system.
That might seem like an exaggeration, but the precedent has been set. Even if this plan were never implemented, it was proposed and approved by the ECB, the European Commission, and by the IMF. The bell cannot be un-rung.
If you had deposits in Cyprus, would you leave any of your assets in place after this "one-time" event? I would certainly hope not. What would stop the authorities for coming back for more? Nothing.
Under the original plan, withdrawals are limited to EUR 400 (to ensure that sufficient funds are available for confiscation). After the deposits have been confiscated, the withdrawal constraint would presumably be lifted. At that point, all rational depositors should transfer their deposits to "safe" institutions in other countries.
As I explained above, even healthy banks would not have sufficient funds to meet these withdrawals. To make matters worse, the assets in Cyprus banks have already incurred serious losses - hence, the bailout. When the deposits are withdrawn, the loan losses remain. The result: insolvency.
Unfortunately, this proposal has endangered Europe's entire banking system. The effects are not limited to Cyprus. If this can happen in Cyprus, what would stop it from happening in Greece? In Spain? In Italy? In Portugal?
Now that the dangerous precedent has been set, any incremental piece of bad news should lead to outsized shifts in deposits from risky to safe institutions. This would only exacerbate the problem for the threatened institutions and for the weaker countries and drive up borrowing rates.
The equity markets are extremely overbought and have been waiting for a catalyst to reverse the trend. This could be that catalyst. Nevertheless, it would be prudent to wait for confirmation of the trend change before betting against a sustained uptrend.
One caveat: the above domino scenario assumes depositors are rational and will transfer their deposits to protect their assets. The fate of Cyprus has been known for some time. Why did depositors still hold deposits in Cyprus banks? That hardly seems rational.
As I write this, the European equity markets have declined by 0.5% to 2.25%. The equity indices in the U.S. are all down less than 1.00%. It will be interesting to see how this unfolds.
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