Robert Pringle’s Viewpoint: Wider lessons of the Cyprus bail-out


Another eurozone rescue package has sparked a new wave of nervousness in financial markets. The tax on Cypriot bank deposits (6.75% for deposits under €100,000 and 9.9% for anything above that level) that creditors have insisted on as part of the deal to ward off the imminent danger of bankruptcy threatens to undermine one of the principles of financial safety-nets and bail-ins - that small depositors are protected. The fact the instrument used is a government tax rather than bank default (which by law would insure depositors up to €100,000) will be seen as irrelevant.

It is also true that Cyprus is a special case, given the huge size of its banking sector relative to GDP (a Fathom report today estimated Cypriot banking assets at 236% of GDP) and its use as an offshore centre, notably by Russian companies, banks and oligarchs. Indeed, it is in some ways encouraging if the proposed bail-out, when approved by the Cypriots, does indeed inflict losses on bank creditors - officials are usually afraid to ‘pull the trigger' on them; and such taboos have to be broken if market discipline is to be restored to banking. Yet such action needs to be complemented by other measures - including a restructuring of bad banks - and, crucially, they must be seen to be fair.

Coming hard on the heels of the International Monetary Fund's (IMF) warning about the risks of allowing unresolved banking problems to linger in the eurozone, the proposed deal over the weekend has naturally renewed the feeling of financial 'fragility' in the near term and, looking further ahead, raised fears about the financial stability of the eurozone. The boost to confidence given by European Central Bank (ECB) president Mario Draghi's adroit reassurance last July, that the ECB would do "whatever it takes" to protect the single currency, has been somewhat undermined.

There are, indeed, wider reasons for concern about the prospects in the eurozone. And the case of Cyprus illustrates some of the lessons to be learnt for policy-makers.

First, let us take a brief look at the economic outlook. Debtor countries are taking much longer to restart growth and reduce spare capacity than had been hoped. According to projections by the European Commission, next year unemployment rates are expected to be roughly 15% in Ireland and Portugal, and more than 25% in Greece and Spain. In the same year, per capita GDP is expected to be 7% above its pre-crisis level in Germany, but 7% or more below in Ireland, Portugal, and Spain - and as much as 24% below in Greece. The North-South split is widening.

Yes, Cyprus is a special case. But in some disturbing respects, it is a microcosm of the problems of the wider Euro area financial system

It is true that progress has been made towards necessary adjustment. Ireland has moved into external surplus while Portugal, Spain and Greece have all greatly reduced payment deficits. Nor does this reflect entirely a collapse of internal demand. Exports have also been recovering. Costs relative to Germany have greatly improved and structural reforms are helping.

Equally, countries have pursued fiscal consolidation, despite its high costs. Some are approaching or have achieved surplus on their primary budget balances. Although debt-to-GDP ratios have continued to rise, owing to weakness of demand, structural deficits have been greatly reduced, meaning that once the economies do recover, debt-to-GDP ratios will fall sharply. They would then establish strong fiscal positions quite rapidly. That in turn would reopen access to international markets - indeed Portugal, Ireland and Spain have all tapped the markets in recent months. But this assumes they can get through the pain of the remaining adjustment needed without turning to extremist policies.

Then there are the obstacles. The biggest obstacle to a speedier adjustment remains the malfunctioning of the European financial system. Good financial intermediation is essential for the real re-allocation of resources from less productive to more productive sectors to take place - which in turn is central to sustained recovery and exit from the debt trap. That is what a good financial system does; it is its key economic function. At present Europe has a ‘pretend' financial system. You see the familiar names of the big financial groups on every high street, so the man-in-the-street doubtless assumes they are doing their job. But this is misleading. Many are little more than hollow shells.

As a report by the ECB shows, unsecured lending has fallen heavily, the market is not seen as efficient or liquid by participants - with a decline in liquidity in 2012. Liquidity worsened also in the secured sector of the market in 2012. A recent report by the International Capital Market Association (Icma) showed a further decline in the European repo market turnover. Icma commented that continued weakness in the market is thought to reflect the effect of the ECB's long-term refinancing operations (LTRO) liquidity, which has meant that banks decreased their reliance on funding from repo operations in the market. (Press release, March 11, 2013.)

But this merely means that the public sector has taken more of the credit and intermediation risk. As ECB board member Benoit Coeure said on March 12:"The money market has become increasingly impaired, especially across borders."

He noted that a similar phenomenon has occurred in the overnight unsecured money market and the secured money market. The fact that participants have shifted from the unsecured to the secured market is just another sign of risk aversion. There had been a progressive reduction in cross-border holdings of governments bonds by financial institutions, and a ‘re-nationalisation' of collateral. Coeure stressed the damaging effects in financial fragmentation:

"All of these developments are problematic from the perspective of the Eurosystem, not least because they exhibit strong pro-cyclical features at local level in euro area countries," Coeure said. "Once unleashed, financial de-integration can be self-reinforcing. If left to its own devices, as we saw in the first half of 2012, de-integration can lead to expectations of disintegration - a euro break-up, which the ECB had to counteract by announcing the outright monetary transactions."

So what needs to change? Coeure and many others pinpoint the need for a banking union, including notably a single supervisory rule-book, a single resolution mechanism and, "looking further ahead", a single deposit protection scheme. He also rightly stressed the need to encourage equity flows and other alternatives to banking. A key benefit would be to reduce reliance of the system on a few big banks, and eventually reduce the ‘moral hazard' that encourages them to grow on the back of implicit state guarantees.

Yet with the survival of the eurozone at stake, can we wait for the years that will pass before these regulatory reforms are in place? More important even than that, will they of themselves, even when in place, produce a healthy euro banking system?

I don't think so. What is needed is not only a bank resolution regime, but for many of Europe's banks to be resolved. Bank of England governor Mervyn King has pointed out with respect to Royal Bank of Scotland that pretending it is an independent entity when it is majority-owned by the taxpayer is nonsense; he rightly called for it to be broken up. The same applies to the continued survival of many of the euro area's financial institutions, kept afloat by courtesy of virtually free public money. Bad banks roll over loans to bad companies, keeping real resources in the wrong places and postponing, rather than supporting, economic recovery. Setting up more bureaucratic structures, however finely crafted they may be even if aimed to ‘align market incentives', will not solve the problem. What is needed is political leadership to restructure European banking from top to bottom.

Yes, Cyprus is a special case. But in some disturbing respects, it is a microcosm of the problems of the wider Euro area financial system - and the challenges facing European governments.

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