ELA, Cyprus, Argentina and the IIF: the structural bull run in creditor confusion

Sid Verma
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The IIF lashes out over the re-privatization of banking liabilities amid the Cyprus bailout and calls for more transparent restructuring principles. But it's not clear there is an alternative.

In 2012, fears that private eurozone sovereign bond holdings were subordinate to the official sector triggered market distress, given the perception in the market that public officials will change the rules of the game to ensure their holdings were insulated from write-downs, come what may, as was the case in Greece.

Fast-forward to 2013 and the Argentina and Cyprus debt-crises confirm this oft-cited fear held by creditors: sovereigns and official-sector creditors have substantial freedom and, thus, a self-interest in determining the creditor priority structure that suits them.

The initial and maddening Cyprus sovereign-bank bailout proposal to force losses on insured depositors but not senior unsecured bondholders makes this all too clear.

Although the eurozone crisis underscores the need for a framework to make the relative priority of creditor claims on sovereigns more transparent, it’s vexing task to develop a system that can be agreed and enforced on an ex-ante basis, and that’s not just down to sovereign immunity laws, as in the case of Argentina.

For claims on banks, restructuring is supposed to be clearer but the ECB press conference on Thursday revealed this structural tension once again. Governor Draghi – who reiterated that political commitment to the euro remains “vastly under-estimated”, boosting the euro – was decidedly frustrated over the tone and nature of questioning.

In particular, Draghi argued the Cyprus bailout is neither a turning point nor a template. But he inadvertently confirmed an obvious truth: in the absence of “explicit policy statements by the Eurogroup about the criteria and procedure to decide on how burden sharing is done, market participants could be left to assume that the process might have been driven opportunistically: go where the money is”, the IIF said in a report before the ECB meeting.

Take Draghi’s comments on the emergency lending assistance (ELA) on Thursday, following the controversial decision to move Laiki's ELA to the revamped Bank of Cyprus, along with insured depositors, suggesting official sector seniority of claims. Draghi said: "there is nothing in the market that says that the ELA is senior, but if you want to remain as a counterparty in the ECB’s monetary policy operations, it should certainly be treated as such."
As Marc Chandler, currency strategist at Brown Brothers Harriman in New York, noted, in response to Draghi’s comments: “ELA is loans from a national central bank to local banks, with the ECB’s approval, but at the risk of the local central bank.

“Banks turn to the ELA facility when they do not have collateral acceptable to the ECB. This [and Draghi's comment] seems to throw the ELA out of the official sector and toward the sector that can participate in haircuts and losses.”

With the ELA’s position in creditor hierarchy norms simply one example of market uncertainty over future debt-crisis resolution plans, like a broken record, the IIF published its monthly capital markets report on Wednesday with a focus on sovereign-bank debt restructuring in Cyprus and Argentina, vaguely emphasizing core principles of transparency,  debtor-creditor dialogue, good-faith, and fair treatment of all creditors. (The same IIF mission – to flesh out a set of procedures for sovereign bailouts amid a disconcerting lack of harmonized principles – took root in 2004 after the outbreak of the Argentine debt fiasco.)

Amid fears over the re-emergence of private-sector liability for sovereign and bank-bailout costs, the IIF verdict on the Cyprus bailout was particularly damning.

It charged: “The rationale for bailing in creditors in bank resolution to protect taxpayers also rings hollow in this case as many taxpayers are depositors and all will suffer greatly from the deeper and longer recession.

“There should be a clear distinction in the discussion between resolving financial institutions in normal circumstances – where the overall banking system is still healthy and the financial system can absorb the losses arising from a few institutions – and during a systemic crisis when most, if not all, of the banking system is under stress and imposing losses on creditors may fuel panic and necessitate capital and banking controls, which could inflict extensive economic damage.”

Private affair

It’s no surprise that a bank-lobby group continues to launch a manifesto against the re-privatization of bank liabilities. The self-interested critique continues: “Various measures announced by the Eurogroup since last summer – with the important goal of breaking the vicious linkage between weak sovereign and bank balance sheets – will not make much progress going forward.

“Instead of mutualization of bank liability in case of need, it has become about bailing in bank creditors and depositors. Such concerns could exacerbate the current outflow of deposits from troubled countries (Chart 6), adding to bank funding strains.”