EU Closer to Bank Union Fails to Help Cyprus in Crisis

On the same day Cyprus’s parliament rejected a European Union bailout involving a tax on deposits, political leaders in the region reached a deal bringing the euro zone one step closer to a banking union.

The agreement to accept a common supervisor was the result of an idea hatched in Brussels in June to enable the direct use of EU funds to recapitalize banks without adding to a government’s debt. It was supposed to help countries such as Cyprus, whose failing banks threaten that nation’s solvency.

That goal is still out of reach. The EU offer that Cyprus spurned would have forced the government to borrow 10 billion euros ($13 billion) to recapitalize banks, pushing its debt load to about 140 percent of gross domestic product. Similar burdens led Ireland to seek a bailout in 2010 and Spain in 2012.

“Like Ireland, the banking system is bringing Cyprus down,” said Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels. “Germany asked for the banking union as a condition for allowing use of direct EU funds for banks, but the crises in Spain or Cyprus didn’t wait for the establishment of the new regime.”

Euro zone leaders agreed in June that a common emergency fund could be used for direct recapitalization of banks once a central supervisory structure was in place. Irish and Spanish politicians voiced optimism at the time that they could transfer some of their liabilities to the fund. Since then, those hopes have been dashed as Germany has made it clear it didn’t want legacy loans to be covered, according to Alberto Gallo, head of European credit research at Royal Bank of Scotland Group Plc.

‘Legacy Losses’

Germany and other northern European countries have a different vision of the banking union than their southern neighbors, said Gallo, who’s based in London.

“Germany, Finland, the Netherlands first want the legacy losses to be paid by creditors or depositors, through some sort of bail-in, before they want to shoulder responsibility for those banks,” he said.

Ignazio Angeloni, head of the ECB’s financial stability directorate, repeated yesterday the June objective of breaking the link between sovereign and banking risk once a central supervisory mechanism is in place, Risk magazine reported on its website. The new regulator would be set up by mid-2014, Angeloni said at a conference organized by the magazine in London. He acknowledged there could be conflicts between national interests and what the central supervisor would want to do.

Burden Sharing

The EU “is composed still of very strong, powerful national authorities -- in all dimensions, political and financial,” Risk quoted Angeloni as saying. “We have to live with this system.”

Politicians in Germany have said Cypriot bank depositors need to share the burden because the island nation can’t bear the public debt increase if it all falls on the government. When Greece’s debt level exceeded 160 percent of GDP, Germany pushed for a restructuring, billed as burden-sharing by the private sector. German and French banks ended up losing money on their Greek bond holdings.

Still, by delaying a default for two years, the EU gave banks in those countries time to reduce their holdings of Greek debt by more than half, lowering the cost to them and shifting two-thirds of the debt to taxpayers. The EU and the International Monetary Fund made loans to the Greek government, which used the funds to recapitalize banks, which in turn paid off their debt to German and French banks.

Russian Creditors

With Cyprus, the outside creditors aren’t German and French banks. They’re Russian companies and individuals who keep money in Cypriot banks to take advantage of the island’s lower tax rates. About 21 billion euros, or one-third of total deposits, were from non-EU residents, according to January data on the website of Cyprus’s central bank.

While Germany has said depositors should share the burden, Cyprus can’t risk alienating its best bank clients and losing a vital source of income. Cyprus President Nicos Anastasiades met with advisers yesterday to draft a new plan, as Finance Minister Michael Sarris held talks with Russian officials in Moscow. Russia rebuffed a request for a bailout loan, saying it would consider investing in Cyprus’s energy sector instead, Sarris said in an interview broadcast today on Antenna TV.

Bank Holiday

The alternative plan may include a new version of the deposit tax, according to an official who asked not to be identified in line with government policy. The central bank said lenders would remain closed until March 26, extending a bank holiday that has been in effect all this week.

“On the one hand, the EU wants to preserve the sanctity of deposit insurance, but on the other they don’t want to bail out Russian millionaires,” Gallo said. “Meanwhile, Cyprus cannot hurt foreigners too much because it needs offshore banking.”

Cyprus’s crisis is in part a side effect of the Greek debt restructuring. The island’s three biggest publicly traded lenders -- Bank of Cyprus Plc, Cyprus Popular Bank Pcl and Hellenic Bank Pcl -- had combined losses of 6.5 billion euros in 2011 after writing down the value of their Greek bond holdings. They also have been bleeding on their loans to Greek companies and individuals.

The divided island’s southern part has close ties to Greece. Bad loans accounted for 27 percent of lending by Cypriot banks at the end of September, according to the Institute of International Finance, a global bank lobbying group.

Contagion Risk

Forcing losses on Cyprus depositors could have repercussions in the rest of the euro zone. It may restart deposit outflows from countries such as Spain and Italy that halted in August after European Central Bank President Mario Draghi committed to unlimited purchases of government bonds.

A total of 378 billion euros was pulled from banks in so-called peripheral countries -- Ireland, Spain, Portugal, Greece and Italy -- in the 13 months through August, according to data compiled by Bloomberg.

“There will be contagion if depositors bear some costs,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy Ltd., a London-based consulting firm specializing in sovereign risk.

If Cyprus digs in its heels and refuses to impose fees on depositors, the ECB could stop financing its banks as it has threatened to do. The island’s lenders stay afloat with about 10 billion euros of ECB loans. The ECB’s governing council renewed its threat today, saying it wouldn’t renew funding for Cypriot banks unless a rescue program is in place by next week.

‘Nuclear Option’

A cutoff of funds would do more than just spook depositors in the euro zone, according to Spiro.

“That’s the nuclear option,” he said. “It would push Cyprus out of the euro and bring into question any other periphery country’s membership.”

The ECB provided 841 billion euros of emergency funding to periphery banks at the end of January, according to the latest central bank data available. That’s down from a peak of 977 billion euros in August.

“If the ECB pulls the plug on Cypriot banks, it needs to be prepared to ring-fence the rest of the banking system in the euro zone,” said Guntram Wolff, deputy director of Bruegel, a Brussels-based research group. “That would mean providing more liquidity to the banks in other countries and buying government bonds left and right. If it’s not a bluff, the ECB had better be prepared to prevent the fallout from such a move.”

Deposit Protection

The sanctity of deposits has mostly been preserved since 2008, even though some EU countries didn’t have deposit insurance before the crisis. Governments still protected all their depositors, mostly through bailing out failing banks. In 2008, the EU ordered all member countries to protect a minimum of 100,000 euros.

In 2011, Denmark became the first EU nation to bail-in bank depositors when it forced some Amagerbanken A/S savers and senior creditors to share losses. While the move affected only depositors holding more than the EU insurance limit, it left its mark on Danish banks by increasing borrowing costs.

Outside the EU, Iceland decided to pay domestic depositors only after the country allowed its banks to fail, leaving out about $5 billion of deposits collected in the U.K. and the Netherlands. The British and Dutch governments made depositors in those countries whole and demanded payment from Iceland.

The almost blanket protection of depositors has been one reason withdrawals from banks in the periphery haven’t soared. Another is higher interest rates paid on deposits. Lenders in those countries and Cyprus are paying customers 3 percent to 5 percent interest on savings, compared with about 1 percent by German banks and 0.5 percent in Belgium, according to ECB data.

Economic Divergence

That means it’s harder for lenders in periphery countries to make money and has contributed to economic divergence between the north and the south as higher borrowing costs are passed on to customers. While Cypriot banks pay 4.5 percent for deposits, the new Greek bonds they received in last year’s debt swap pay them about 2 percent.

Germany might have to back down from its stance against Cyprus if it wants to keep the euro together, said Horst Loechel, an economics professor at the Frankfurt School of Finance & Management. It would be better to use central euro zone funds to bail out Cypriot banks as the EU promised in June rather than risk bank runs in the rest of the region, he said.

“You can’t make Europe’s savers fret over the safety of their funds because of just 5 billion euros,” Loechel said. “That’s ridiculous.”

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