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Thoughts from the Frontline

You Can’t Be Serious

March 27, 2013

I admit to being surprised by Cyprus. Oh, not the banking crisis or the sovereign debt crisis or the fact that its banks were eight times larger than the country itself or even the fact that the banks were bloated with Greek debt that had been written down. I wrote about all that a long time ago. What surprised me was that all the above was apparently a surprise to European leaders.

While there is much to not like about what European leaders have done since the onset of their crisis some five years ago, they have demonstrated a prodigious ability to kick, poke, and massage the can down the road, to defuse crisis after crisis, and to indefinitely postpone the inevitable. They have demonstrated a remarkable ability to spend taxpayers’ and others’ money in order to keep Europe and the euro more or less in one piece. At every step they have been keenly intent on maintaining trust in the system. That they have been successful in keeping a majority of citizens in favor of the Eurozone and the euro, even in countries forced to endure serious austerity, must be recognized.

However, the shock in Cyprus reveals an absolute lack of preparedness in dealing with a problem that had festered for several years. By now it should be no surprise to anyone that sovereign nations can default, that banks can go bankrupt under the weight of defaulted sovereign debt, and that banks can be too large for some countries to bail out. That a clear and consistent response to Cyprus should have been worked out in the halls of Brussels and the ECB seems so, well, reasonable. Clearly, the large depositors in Cypriot banks, the majority of whom were Russian (according to Financial Times reports) thought the Eurozone had a plan. In fact, the apparent assumption, bordering on religious faith, that Eurozone leaders would not allow depositors in Cypriot banks to lose one euro, is almost touching. This snafu is going to have repercussions that spread far beyond this tiny island nation. Let’s look at a few of the implications.

You Can’t Be Serious

When we woke up to the Eurozone pronouncement that all depositors in Cypriot banks, no matter the size of their deposits, would take a loss my reaction was somewhat akin to John McEnroe shouting, “You can’t be serious!” to a line judge whose call he infamously questioned.

While there was no official deposit guarantee in place in Europe, the implicit guarantee was €100,000, a number that…

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Ronald Nimmo

March 28, 2013, 12:49 a.m.

I agree with E Paul Jacobsen and would further add that this process makes a strong statement that in the future large depositors perform their own risk management rather than expecting the ECB and Northern European taxpayers to do it for them. This is a first step in the EZ extricating itself from the “too big to fail” syndrome. As John insightfully points out, there will be side effects but their cost will ultimately be much less than continuing to reinforce the “moral hazard” of unlimited bailouts.

Ronald Nimmo

March 28, 2013, 12:32 a.m.

RE: Or is Cyprus a one-off because most of the losses are Russian and who really cares about those commies anyway?

Russia is not a Communist country anymore and has not been one for 22 years.

March 27, 2013, 7:01 p.m.

We’ve all seen how each of these bankruptcies has a very long and twisted tail that sometimes knocks over surprising crockery.  Just like the failure of the Cypriot banks is due to the Greek bond haircut in 2011, it will be awhile before we see all the Cypriot dominoes falling. Though I agree that the initial effects will be seen in the Euro Zone banks, the more profound effect may be greater in the truly shadowy banking sector where criminals and tax-avoiders have off-shored their wealth. By definition, these centres specialize in no transparency at all. Though normally that is their prime attraction, in a crisis it may be their undoing, as rumours will become the exclusive drivers of events. For example, if someone was to say that elements of the Russian Mafia were having a cash flow problem, due to Cyprus and were now pulling enormous sums out of the Cayman banks, causing tremors there, who could credibly deny it? And why would you believe them?

Plus, the sums there are large and the owners tend to be a self-selecting group of active managers of their money. These are not individuals that will passively wait to see what happens. Mitt will be all over it.

Plus, there is a fair chance that we begin to see actual violence, by professionals. Tony Sopranokoff, will not be happy with losing all those rubles washed into clean Euros. This will lead to instability and bankers turning state evidence in exchange for protection. They will be likely offering up the tax-avoiders, first and foremost, as politicians everywhere are hungry for tax revenue. Plus it’s very popular with the voters.

Now, like everyone, I am appalled by the amateurishness of the Euro Zone politicians and their hapless market-destroying statements. However, beneath the clownish ineptitude there may be a determined game being played. As the neo-cons taught us, never waste a good crisis and this crisis offers a terrific opportunity of destroying all the off-shore banking jurisdictions, starting with Cyprus. If they are too big to jail, let’s just take their ill-gotten lucre. The 1% take a 99% haircut!

To see that Cyprus is part of a determined effort against tax havens read on Der Spiegel Online: Bailout Insights: What Cyprus Tells Us about Germany’s Character A Commentary by Tyson Barker.

Interestingly here in Canada, where I live in Toronto, the Finance Minister just announced a crackdown on off-shore money. What do they talk about at those G-20 meetings anyway?

Damir Andrei

March 27, 2013, 4:20 p.m.

John this one was not up to your standards. I am a long and faithful reader, and not a critic. Keep them coming!

Depositor risk responsibility for deposits exceeding insured limits is well established in American banking. Wise depositors spread the money around. However, depositors in large banks ignore the insurance limits, probably because they think size is synonymous with safety. Depositor risk responsibility for over-insurance-limit deposits squares with handling of unsecured claims under U.S. bankruptcy law. It provides discipline to the system, and to ridicule use of that path by foreign countries is to lack perspective. Don’t feel sorry for the large depositors. They can, and will, look after themselves. That is how they became large depositors!

Undercapitalized banks usually solve their capital problems by shrinking the balance sheet. This is the probable path European banks will have to follow, and Dijsselbloem has correctly herded them down that path. It will get messy, but it’s the cheapest route for the EU to follow and will obviate a lot of arguments downstream. Good business judgment by the EU!

Europe-wide deposit insurance is inappropriate at this time. As every professional manager knows, accepting upward-delegation of problems is disastrous, and EU management correctly isn’t doing that. The answer is: Push the problems back to the countries that caused them, and force resolution there.

By the way, home loans were long excluded from calculations of risk-based capital in the U.S. banking system. The European country practices excluding sovereign bonds owned by banks merely follow a long-established political principle.

Allan Dalshaug (writes as Alan Hillsdale)

Dallas Kennedy

March 27, 2013, 3:56 p.m.

The EU is stumbling toward a US-style deposit insurance, one that limits protection to smaller deposits. That’s fine.

What’s the matter is this: as John says, we’re not talking here about about a SINGLE banking system backed by a SINGLE EZ-wide insurance system. Instead, we’re looking at national banking systems, regulated and bailed out by national governments. That destroys the point of a single currency. Add capital controls to prevent deposit flight, and you have a “Cypriot euro,” a “Dutch euro,” a “Slovenian euro,” etc. It’s hard to see how the EZ can survive under such conditions.

Of course, you can’t ignore the very different nature of the European banking system from the US system. Over there, the banks depend much more heavily on deposits, are far more leveraged, and have far more assets per GDP than our banks do. They are also far more invested in sovereign debt. Our banks look good by comparison. It makes large bank failures there seem inevitable. Here, getting C to failure took a lot of hard work :)

That’s not to say that our large banks shouldn’t be broken up. In fact, it’s time to scrap Dodd-Frank and reinstitute something much simpler, a form of Glass-Steagall. Our euro-style “universal” banks (the TBTF ones) will have to break up. Higher capital ratios (self-insurance) should do the rest, including for the pure investment houses (MS and GS), which should be moved out of the bank category completely.

Kristi Rohtsalu

March 27, 2013, 10:44 a.m.

Financial (analyst) communities are sometimes difficult to understand: on one hand they are looking for truth, on the other hand they don’t want to hear that truth being told. I’m referring to the remarks of Mr. Dijsselbloem, and what the reactions have been.

Comparison of the European banking system and the US banking system doesn’t look quite right in the David Stockman’s paragraphs given the differences between the US GAAP and the IFRS when it comes to consolidating off-balance sheet vehicles. US banks would be much bigger and much more leveraged than they currently look if they were to apply the IFRS rules.

Having said that, I think that indeed: a full-fledged bank / financial panic is not that unlikely at all in Europe (with or without Cyprus and Mr. Dijsselbloem’s remarks).

Here are some highlights from the February / March EU Financial System Stability Assessment by the IMF, and the recent Lagarde’s speech on Frankfurt Finance Summit (I’m referring to the IMF, ECB and EC as “they”):

* They don’t know what the asset quality is in banks and they have even less idea about the shadow banking. Thus, they possibly cannot have a reasonable idea about the magnitude of the underlying problems either – which basically makes all the reassuring statements by the IMF and the Troika pretty empty / unfounded.

* They however are highlighting tricky asset valuation practices, subjective definitions of non-performing loans, “zombie” banks keeping alive “zombie” companies in order to avoid banks going bust, tricky calculations of the regulatory capital which allows banks to show high capital ratios even if re-capitalisation is badly needed in reality.

* They indicate that in the prevailing low interest rate environment, the traditional business models of insurance and pensions companies’ may throw into question, suggesting that significant refocusing or restructuring may ultimately be called for.

The list goes on. The details are here:
and here:

We don’t know what the upcoming selective asset quality reviews will reveal and how the huge debt hole will be overcome. One “European pot”, re-capitalisation of banks, more bail-ins and rather extensive bank resolutions and restructurings are parts of the proposed solution. It remains to be seen how all this will play out, especially considering the national interests etc. Given the integrated nature of the financial system, one could be wondering if there is any safe place at all for savings, at least above certain limit.

Gerald Lampton

March 27, 2013, 9:28 a.m.

I must say that, unlike almost every commentator I read, I feel that the EU is handling the Cyprus situation correctly, assuming the implicit insurance guarantee on smaller deposits is honored.

Deposit insurance (in the U.S. at least) is intended to protect small depositors from the consequences of bank runs.  It is not intended to gurantee all bank deposits, regardless of size.  Those who wish to place deposits worth more than the ceiling on deposit insurance with any one bank should be required to assume the risk that the bank will fail, just as they did before the creation of deposit insurance.  In the long run, that principle will lead to a sounder banking system because it will force large, sophisticated depositors to evaluate the financial condition of the banks they do business with before placing their deposits, causing reckless banks to receive fewer deposits than prudent banks and eventually to go under if they do not change their ways.  That is exactly how banking is supposed to operate in a capitalist system.

I would love to see an analysis of how the banking system of a capitalist contry is supposed to operate, with and without deposit insurance, and without regard to unwritten and incohate “national guarantees” on larger deposits, and see what advatages and strengths, as well as disadvantages, having the banking system operate that way creates.  Then, place that analysis side by side next to what the European Union is doing in this case to see what the differences and similarities are, and why they exist.

Perhaps if the U.S. had adopted an approach similar to what the EU is doing now, instead of TARP, the U.S. banking system might be in a better place today, with less risk and no “too big to fail” banks, albeit there would be a lot of pissed off (and perhaps unemployed) bankers and rich people.

Greg Webbink

March 27, 2013, 6:08 a.m.

There are inconsistencies in this ‘Thoughts’ when compared with the Wall Street Journal yesterday, - Bailout Strains European Ties.  The center of incompetency appears to be the Cypriot nomenklatura, not the EC.  There is not a central European banking authority, so to expect top-down remedies is a paper tiger.  And if there’s a country that trampled over the ‘rights’ of senior bond-holders, it’s the US through Obama, Geithner, and Steve Rattner in their treatment of senior bond-holders the US auto industry.

It’s ironic that those,  who complain that TBTF has not been remedied, seem to get squeamish when it’s actually addressed.

EPual Jacobsen

March 27, 2013, 5:57 a.m.

It has all been neatly planned.

EU would not give bailout of what was considered

“Russian tax avoidance money,
Russian safe haven, Russian illegal money”.

Or at least the German people would not stand for it,
without risk to Merkel.

No way shall you bail out the Russian Oligarchs.

So what do you do about that ?

Freeze Cyprus banks, BUT
allow Russians to remove this money via Cyprus bank branches
located in Russia.

Now the EU citizens/German people, cannot be angry
about a bailout used to protect
Russian money.

The Russian money is gone, they will be asking for bailout
to protect local Cyprus citizens.

Now Merkel is saved.

Nicely played.

Robert Guilford

March 27, 2013, 5:15 a.m.

I wouldn’t sleep well if my $100k deposit insurance was backed by the Cyprus government. Insurance or not, few will be able to withdraw their $100k. The ECB should back all deposits, not nations. The EU is lunacy.

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