Almost like a bolt from the blue, the Eurogroup meeting of euro-area finance ministers, along with the troika of the European Commission, the European Central Bank and the International Monetary Fund, agreed on March 16 to a tax on all deposits in Cyprus, including small deposits.
During the subsequent few days policymakers all busily disclaimed all responsibility for the decision -- a typical European nonsense. Then the Cypriot parliament turned around and rejected the deal, after which the country sought help from Russia – without success. Cyprus ended up reaching a new agreement with the Eurogroup and the troika on 25 March, to avoid a disorderly exit from the euro area.
The new deal is quite sensible in a number of aspects: it fully protects all insured deposits up the €100,000 threshold of the deposit guarantee scheme. Bank shareholders and big creditors take the first hit, while deposits over the €100,000 threshold of the troubled banks will also have to bear the burden of bank losses and contribute to bank recapitalisation as much as needed.
Yet the involvement of uninsured depositors sparked a major controversy: will this be the new 'template' for dealing with banking crises in the euro area in the future? The answer is clearly no, even though the communication fiasco that resulted from the public disagreement did not help matters.
The Cyprus case is special. The capital shortfall is estimated at about a half of Cypriot GDP: I cannot imagine a banking loss of this magnitude in any other country. And someone had to bear these Cypriot losses. The government did not have the fiscal means to absorb them; Russia did not step in with a huge grant; and euro area partners did not want to burden their taxpayers further. The only remaining solution was to involve bank shareholders and lenders, including uninsured depositors.
It is likely that there will be more ‘bail-ins’ in Europe in the future - that is, involving owners and certain investors in the cleanup of banking losses. But these will be along the harmonised principles of the soon-to-be-adopted Bank Recovery and Resolution Directive (BRRD). This in fact aims to protect deposits.
Even if Cypriot banking mess is a unique case, it has made one broader lesson abundantly clear: the euro area needs to adopt a fully-fledged banking union. Under this, bank supervision, resolution, and deposit guarantees would be centralised in euro-area countries, as well as those non-euro countries of the EU that decide to opt-in.
As things stand, we are only part of the way there. The agreement on centralised supervision has been reached, and banks in the participating countries will be supervised by the ECB, most likely from the middle of next year. In itself this will be a major plus, because the ECB will presumably do everything to avoid flops like the Cyprus disaster, or the sudden crumpling of Dexia in Belgium and the Dutch financial conglomerate SNS Reaal.
But it won’t be enough. Trust in deposit insurance has been shaken by chain of events in Cyprus. This may indeed be a special case, but not all small depositors throughout the euro area will understand this. The grave mistake of introducing payments and capital controls in Cyprus to stop money flowing abroad will make matters worse.
To rebuild that shattered trust, euro area-wide deposit insurance will be needed. On top of this, a euro-area resolution authority equipped with a well-defined toolbox along the lines of the BRRD is needed in cases of bank failures. And there has to be a burden sharing agreement on eventual banking losses, otherwise, a half-baked banking union will not separate banking and sovereign risks from each other, which would have detrimental effects of the economy.
The Cyprus crisis may be contained for now, but it is not over. The payment controls will deepen the already bleak economic outlook, because even the few relatively healthy banks will not be able provide adequate financial services to the economy. The deep economic contraction ahead in Cyprus will make it very difficult to implement the fiscal and structural adjustment programme, and therefore we cannot be assured that Cyprus is saved.
Cyprus’s situation is so desperate that it has no choice but to forge ahead with fiscal consolidation and structural reforms. This is not the case in most of the euro area, where fiscal accounts are much stronger. Boosting private investment in core euro area countries with tax breaks, or even increasing public investment financed from government borrowing at the close to zero rates, would revive the economy of the euro area core -- with positive spill-overs to southern Europe.
The time has also come to engineer a massive investment programme for southern Europe, like a kind of new Marshall-plan. After all, every euro-member is responsible for the defunct architecture of the euro that allowed the build-up of vulnerabilities that are now causing suffering to millions of people.
This column was published in The Times: http://www.thetimes.co.uk/tto/business/columnists/article3728435.ece