Blog Post

Cyprus deal: the right intentions but major flaws

On Saturday morning, after a marathon meeting of the Eurogoup, it was decided to impose a one-time wealth tax on deposits in Cypriot banks: 6.75% on deposits below €100,000 and 9.9% on deposits above this threshold. Involving depositors was a wise decision and a wealth tax is a mild form of bailing-in, as I argued in a post last week.

By: Date: March 18, 2013 Topic: Macroeconomic policy

On Saturday morning, after a marathon meeting of the Eurogoup, it was decided to impose a one-time wealth tax on deposits in Cypriot banks: 6.75% on deposits below €100,000 and 9.9% on deposits above this threshold. Involving depositors was a wise decision and a wealth tax is a mild form of bailing-in, as I argued in a post last week.

The intentions are right, because, as a first principle, taxpayers should not foot the bill for private-sector losses. In Cyprus, there is a special aspect related to suspected money-laundering, but in any case, tax rates were so low in Cyprus that the return over a longer period, even considering the one-time wealth tax on deposits, will likely exceed the return in other countries. Also, without a bailing-in of depositors, a publicly funded bank rescue in Cyprus would have seriously endangered fiscal sustainability. Without a bank rescue, Cypriot banks would have collapsed, leading to much worse outcome for all involved.

However, the agreement has two major deficiencies.

The first is that it involves deposits below the €100,000 amount guaranteed by deposit insurance. This was not necessary and can undermine the trust in deposit guarantee systems throughout Europe. A simple calculation: assuming that the total amount of deposits in Cyprus declined from €68bn in January to €65bn today, the announced tax rates and the amount of money to be collected (€5.8bn) imply that the amount of deposits below the €100,000 line is €20bn and the amount above the €100,000 line is €45bn. To protect deposits below €100,000 in full, the tax rate had to be 12.9% on the deposits above €100,000 in order to collect €5.8bn. This is a back of the envelope calculation, yet the difference between the decided 9.9% tax rate and this implied 12.9% tax rate is so small that I cannot find a justification for involving deposits below the guaranteed amount.

The second major drawback is the silence about senior bank bondholders. The Eurogroup statement only mentions the involvement of junior bondholders. Unfortunately, reliable information is not available on the number of bank creditors beyond the amount of bank deposits; latest reports suggest that there is not much there. Yet taxing small depositors, while exempting senior bondholders, is unjust.

The Cypriot parliament has not yet passed the tax deal and therefore there should be a scope for revision. Yet the damaged has already been done.

Let us turn to some broader questions. Will bailing-in depositors, especially small depositors, be the new norm in Europe? Extremely unlikely. While the contours of the Single Resolution Mechanism (SRM), the second major plank of the European Union’s banking union project, are not known, the SRM will most likely be in line with the Bank Recovery and Resolution (BRR) Directive, which was proposed by the Commission in June 2012 and is expected to be adopted in summer 2013. One of the aims of this directive is to protect depositors.

Should depositors in other countries worry until the BRR and the SRM are adopted? They should not. The bank rescue programmes in other countries with weaker banks, such as Greece, Spain and Portugal, are fully funded by the financial assistance programmes and there is no intention to involve depositors. Governments should tell their citizens that Cyprus was an exceptional case due to its gigantic banking system (relative to GDP). At the same time, they should speed up efforts to shore-up their banks.

It is a pity that the Cyprus deal had some major drawbacks, despite the good intentions, and the lack of adequate information on the details of the financial assistance programme raises a large number of concerning questions. Markets have not reacted forcefully so far: the euro slid a bit and the yields on government bonds of southern euro-area members slightly increased (much less than after the February Italian elections). So let us keep fingers crossed that it is not too late to correct the Cyprus deal’s drawbacks.


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