Contagion fears grow as Cyprus bailout proposal breaks taboos

Sid Verma
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The proposed raid on insured depositors in Cyprus threatens a wave of unintended consequences for the eurozone's stability in the long-term and throws into sharp relief the political fragmentation at the heart of the EU, say hawkish analysts, bucking the largely sanguine sell-side consensus. Irrespective of the final terms of any bailout, the damage has already been done by breaking taboos.

The controversial proposal to impose losses on insured bank depositors in Cyprus – in a €10 billion bailout largely without historic precedent – has raised the spectre of a new phase in the eurozone crisis, without urgent redress, according to some hawkish analysts, bucking the hitherto relatively sanguine market reaction.

The proposed raid - which could soon be ultimately defeated - on Cypriot deposits highlights the absense of an EU common liability plan, exposing the chronic nature of political fragmentation in the single-currency bloc, analysts say.

The prospect of depositor flight, especially among corporates, and the negative banking sentiment in Greece, Spain and Italy should trigger new crisis-stabilization efforts among eurozone policymakers, analysts say, departing from the sell-side consensus that the bailout plan is exceptional in nature and any contagion would be limited.

 Protesters in Cyprus. Source: Reuters
On Monday, Cyprus was reportedly preparing new proposals that would see depositors with up to €100,000 taxed at a lower rate of 3%, while savers with €100,000 to €500,000 would be taxed at 10%, and balances above this threshold at 15%. The original and much-maligned tax proposal, in return for bank equity, saw every depositor under €100,000 taxed at 6.75%, and those over this benchmark at 9.9%. By Tuesday lunchtime, the plan was hanging in the balance amid a wave of dissent in the Cypriot parliament. Irrespective of the final terms of the bailout, the damage has already been done, say analysts. On March 6, Euromoney broke the news that policymakers were planning the controversial depositor bail-in policy in a bid to ensure foreign depositors share the pain while only a small proportion of banks’ liabilities comprise bonds, meaning the burden of adjustment was always going to fall on regular Cypriot taxpayers in a German election year that has reduced the prospect of direct fiscal transfers.

The deposit equity-swap has been interpreted as a de facto haircut for those that are covered by the deposit guarantee (on balances up to €100,000) but it has been billed by Nicosia as a tax to side-step legal challenges. Burden-sharing has also been imposed on subordinated bond holders. European policymakers claim the structure of the Cypriot bailout is exceptional, citing the fact the banking sector is seven-times larger than the country’s GDP, with the latter representing just 0.2% of the EU’s GDP.

Irrespective of the structure of the levy, the tax, and the decision not to force senior unsecured banks’ bondholders to take a hit, violates the fundamental principle that insured deposits sit at the top of the creditor hierarchy in any restructuring, and undermines confidence in the EU deposit protection scheme, more generally, analysts say.

Contagion risk

Analysts at UBS say: “In the event of the peripheral economies requiring additional capital, the risk is that a precedent has been set. The EU has signalled that it will consider depositor bail-in rather than letting a country’s debt/GDP level rise to an unsustainable level. Clearly this provides a catalyst to start a bank-run at a point when the impact of such is most likely to be catastrophic for the economy involved which, in turn, is likely to make a resolution more challenging.”

The tremors from the Cypriot crisis could reverberate for years to come, knocking confidence in the integrity of a critical instrument to stabilize the eurozone banking system: depositor insurance. “The US created its deposit insurance scheme in the 1930s to restore confidence at a time that deposits looked seriously at risk,” Nomura analysts say. "The euro area might have lost the opportunity to create such a guarantee scheme at the regional level for a long time."

On the upside in the short-term at least, Nomura analysts say systemic eurozone risk will be mitigated by the provision of central banks’ liquidity facilities. “The combination of ELA and ECB liquidity can match every euro of deposit flight for as long as there is enough collateral available," they say. "In extremis, the issuance of debt guaranteed could be considered.” 

Photo from Spanish satirical weekly magazine rightly or wrongly nails the populist view on Germany's role in Cyprus.

Source: El Jueves
Jennifer McKeown, analyst at Capital Economics, adds: “Aside from Greece, deposit flight from eurozone banks has been limited during the crisis so far. But now that the cat is out of the bag that deposits can be hit, there is surely a huge risk of deposits flowing from other countries’ banking sectors, putting an increasing burden on the ECB to fill the gap.”

Malcolm Barr, a well-respected eurozone economist at JPMorgan, recommends a raft of eurozone policy measures in a bid to reduce any contagion, including a “heightened” commitment by the ECB to boost term liquidity and ease collateral rules as well as fiscal forbearance, such as a one-year moratorium across the region on new wealth taxes, until harmonized arrangements for deposit insurance are in place.