Cyprus: The rule or the exception?

Posted on Posted in Financial Blog

To avoid the collapse of its banking system, European Union member nation Cyprus has begrudgingly accepted an unprecedented plan from the EU to raise bailout money. Normally a bailout would come in the form of the government purchasing Cypriot sovereign debt on the open market, but Cyprus is a rare case because its financial sector accounts for about eight times the country’s annual GDP, so a traditional bailout isn’t an option. If the agreement between Cyprus and the EU goes through, depositors (account holders) would be the ones funding the bailout needed to stabilize the Cypriot banking system. While deposits up to €100,000 will be safe under the agreement, balances over that threshold will be taxed to the tune of approximately 20%. This would certainly be an unprecedented action (for the EU), and will likely cause European investors to be very cautious of keeping too much of their funds in European banks.

The exception?

There is a strong case to be made for this instance being an exception to traditional sovereign bailouts and not a new precedent going forward. Cyprus is well-known as an “attractive” place for foreigners to house their money, due to an advantageous tax structure and banking rules in the country. However, with this distinction comes a great deal of illegal funds, likely profits from tax evasion, drug dealing and other activities that would require a safe haven for money. So while the EU previously promised that the ECB is willing to buy the sovereign debt of its member nations as is needed to avoid a financial collapse, Cyprus is seen as an “exception” of sorts, probably because a large percentage of its depositors are foreign and many of them involved in illegal activities. So while the EU is forcing Cyprus to shake down its depositors in this instance, it seems like if Spain, Italy or another large EU nation were on the brink of financial collapse this would not be the method used to inject capital into the banking system.

The rule/new precedent?

On the flip side, there is an equally strong case as to why this may be the rule going forward. If you’ve been following the Cyprus chaos this week in the news, multiple sources have called Cyprus’ (intended) actions unprecedented throughout history. But this is not the case—in 2008, Pasadena-based IndyMac Federal Bank collapsed and its depositors only received 50% of their deposits in excess of the FDIC’s $100,000 threshold. So whether you consider the US’ financial system more or less secure than that of Europe, we can agree that they are similar in their size and stability, and it stands to reason that if it can happen in the US it can certainly happen in Spain, Italy or any other European nation no matter how large. So it will be hard to convince European investors that their money is perfectly safe in a European bank. The arguments are strong both ways, which basically tells us that any outcome would be possible if the situation were to repeat itself down the road. It is our opinion that because of the dubious nature of deposits in the Cypriot banking system, this is a one-time solution to this issue and that the situation would be handled differently if it were a bigger, more prominent European nation whose banking system doesn’t dwarf its entire government in size.