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EU sells out over Cypriot capital controls

European authorities hope their repeated assurances that Cyprus is a special case will curb contagion and ensure the fiasco there does not set a precedent for future bank crises.

Cyprus scored a spectacular own goal with its original plan to impose a haircut on all deposits, even the insured, in the country. The fact such a solution was contemplated throws the whole deposit insurance scheme into doubt, suggesting depositors were at greater risk than previously believed.

From the moment such a plan was considered, a run on banks, or capital controls, should have been seen as an inevitable consequence. “In this specific case there was probably no other way out,” says Marco Valli, economist at UniCredit.

Jon Danielsson, director of Systemic Risk Centre, LSE

Now the goal is to achieve an orderly retreat from capital restrictions. Cyprus will need the ECB to provide liquidity to its banks, as is the ECB’s duty to solvent banks in member countries, says Jon Danielsson, director of the ESRC-funded Systemic Risk Centre, London School of Economics. It must also stress there will be no further losses, and emphasize that the European deposit insurance system covers all deposits under €100,000, he adds.

And Danielsson believes if this had been done before Cypriot banks opened on Tuesday, neither capital controls nor a bank run would have been necessary.

Neither should the EU have allowed capital controls within its borders, he says, adding: “It is worrying that the EU was willing to violate one of the founding principles of the European project for short-term economic advantage.”

This touches on the debate about the legality of the capital controls, which include: a €300 limit on cash withdrawals; prohibition on cashing of cheques; considerable restrictions on foreign transfers; a requirement that fixed-term deposits are held until maturity unless used to repay loans with the same bank; and a €1,000 limit on cash taken abroad.

The measure certainly contradicts the spirit of the European Monetary Union, although such controls are explicitly allowed under the European Treaty in times of national emergency, under article 65b.

However, capital controls that go beyond the mere introduction of withdrawal limits and extend to outright restrictions on investment outflows would contradict EU rules, making Cyprus a second-class citizen of Europe, says Cosimo Marasciulo, head of European government bonds and FX at Pioneer Investments. “It is hard to predict what will be of an economy in such dire straits, but a serious recession is all but probable and some may wonder if the hated bank levy would have been better,” he says.

The official line so far has been the original plan to impose a haircut on all bank deposits, and the later decision to take the money from Cypriot depositors with more than €100,000, rested with the Cypriot government alone.

However, for the integrity of the Europe-wide deposit insurance scheme, European authorities should have stressed the original plan was in breach of EU rules.

What was unique about Cypriot banks was the scale of their reliance on depositor funding, and the almost total absence of equity- and bondholders to absorb the losses before they hit those depositors.

Despite that precedent being established, it is unlikely to affect many other eurozone banks, most having enough bondholders to provide a buffer.

With its inflated banking sector, at roughly 800% of GDP, it certainly reverberated with echoes of Iceland – another country that imposed temporary capital controls, with which it still lives, five years on.

Yet EU leaders stand accused of crossing the Rubicon by drawing bank depositors into the crisis. “Money in the bank” used to convey a bullet-proof investment, but the phrase might lose some of its potency, adds Marasciulo.

And that was not the only first Cyprus achieved. The crisis also marks the first occasion where senior debt has been wiped out, says Valli.

The crisis has left European authorities in a difficult position. “On the one hand, one could rightly ask for more clarity about what is the formal resolution mechanism,” says Valli. “If deposits are to be liable for losses, there needs to be a homogenous system throughout Europe so it is clear how that will work.”

On the other hand, it might be such an action is unnecessary, with the market understanding well enough the key principles, and the reality that occasionally special cases arise requiring an ad hoc solution.

“It is an extremely difficult trade-off because an explicit statement could also have negative consequences for bank funding costs,” says Valli.

Danielsson adds: “I would be very surprised if the EU came out with any explicit guidelines about how this will work in the future. The principle of constructive ambiguity is useful in these situations because it prevents the market from gaming the system.”

Either way, the chances of capital controls in Cyprus causing a run on banks elsewhere in Europe seems, for now, remote.

However, depositors will want to know their banks are well capitalized – and there are bondholders before them in the queue when losses accrue.