WTF is happening in Cyprus?
One thing I kept track of while I was away was the ongoing, intensely interesting situation in Cyprus. For those of you who have been following it just as closely, this will not be new, and please correct me if you think I’ve gotten something wrong.
Background
Cyprus banks have recently gotten deeply in trouble, partly because of their heavy investment in Greek government bonds which as you remember were semi-defaulted on in spite of them being “risk-weighted” at zero, and partly because of an enormous amount of Russian money they hold (Russian businessmen enjoy lowering their taxes by funneling their money to Cyprus), which created a severely bloated financial sector.
To be fair, just having deposits of rich Russian businessmen doesn’t make you fragile. But it’s just not done in banking, I guess, to simply hold on to money – you have to invest it somewhere, and they invested poorly.
To get an idea of how bloated the finance sector is and how badly the banks were hurting, if the Cyprus government was to give them the money they need, it would be 70% of GDP, and they’re already about 90% of GDP in debt. Even so, that’s only 17.2 billion Euros, or a bit more than twice Steven Cohen’s personal fortune ($10 billion) even after his firm, SAC Capital Advisors, settled with the SEC for insider trading “without admitting nor denying wrongdoing”.
What are the options?
- Do we ask the government of Cyprus to prop up the failing banks? Then it (the government) would be underwater and people would stop investing in its bonds and we’d need a bailout of the government. In other words, we’d just be handing the hot potato to the people.
- Does the EU or IMF loan money to government to give to the banks?
- Or to banks directly? Either way this would feel wrong to the northern European taxpayers, who would be essentially bailing out a bunch of Russian businessmen. Europeans are suffering from bailout fatigue, and German elections are coming up, making this even stronger.
- Or do we make the banks deal with their solvency issues themselves? After all, their shareholders, bond holders, and depositors all represent money they have which they can theoretically keep.
- Or some combination? Actually, all plans below are combo plans, whereby the banks make themselves solvent and then, after that, the EU/IMF team kicks in a few billion euros. Whether it will be enough money after the ricochet effects of the plan is not at all clear.
Plan #1: anti-FDIC insurance.
The plan as of more than a week ago was to take money from all the accounts as well as bond holders and shareholders. This included even the so-called insured deposits of accounts below 100,000 Euros.
So normal people, who thought their money was insured, would be paying 6.7% of their savings into a so-called “bail-in” fund, and people with more money in their accounts would be paying 9.9%.
This was across-the-board, by the way, for all Cyprus banks, independent of how much trouble a given bank was in. The banks closed down before this was announced so people couldn’t grab their money.
Compare that to the US version of a bailout from 2008, when shareholders got partially screwed, bondholders were left whole, deposits were untouched, but taxpayers were on the hook (and still are).
Plan #1 was baldfaced: it was saying to the average person in Cyprus, “Hey we fucked up the banks, can we take your money to fix it?”. It was incredible that anyone thought it would work. The ramifications of such an anti-FDIC insurance would be immediate and contagious, namely everyone in any related country would immediately start pulling their money out of banks. Why keep your money in an institution where you’re surely losing 7% when you can hide your money in a suitcase with only a small chance of it getting stolen?
Reaction by public: Hell No
Needless to say, the people in Cyprus didn’t like the plan. In fact, they strongly objected to directly paying for the mistakes of rich bankers and to protect Russians. They protested loudly and the Cypriotic politicians heard them, and voted down plan #1.
Plan #2
Since plan #1 failed, how about we just take money from uninsured depositors? Oh, and also make it bank-specific. So the banks that are in bigger poo-poo would seize more of their deposits than the banks that were in less poo-poo. That makes sense, and seems to be the current plan.
Problems with the current plan
There are a few problems with the new plan. But mostly they are what I’d call transition costs versus long-term problems. Easy for me to say, since I don’t live in Cyprus.
Rich people moving their money
First, rich people everywhere will no longer park lots of money in uninsured accounts in weak banks. Rich people have lots of options, though, so don’t feel too bad for them. They will instead put their money into lots of little accounts in lots of places, each of which will be insured. If this means they distribute their money over more banks, this is good for the banking system because it diversifies the capital and we’d end up with lots of biggish banks instead of a few enormous banks.
I’m not sure what the technical rules are, though. Say I’m stinking rich. Can I open 15 Bank of America accounts, each with $250K and so FDIC-insured? If I can’t do that for my local Bank of America branch, can I use Bank of America subsidiaries? Are the rules the same in the US and Europe? These rules are all of a sudden more important.
This is a transition cost, and within a few months all of the rich people will have their accounts insured or hidden.
Job losses
Second, there will be severe job losses in the bloated finance sector in Cyprus. Right now there are protests by workers from Laiki Bank, which is the worst off Cyprus bank, because they’re poised to lose their jobs. Again, it’s easy for me to say since I don’t live in Cyprus, but that’s what happens when you have an industry that’s too big – at some point it gets smaller and people lose jobs. I was around when the same thing happened to fisherman off the coast of New England, and it wasn’t pretty.
Again, though, it’s transitional. At some point the number of people working in banks in Cyprus will be reasonable. The question is whether they will have found another industry to replace finance.
Capital controls
The banks re-opened today, and of course people are standing in line to get cash, but things generally seem calm.
The big problem for businesses in Cyprus is that various “temporary” capital controls (which just means limits on taking money out of the country and on taking money from your bank) have been put into place that may lead to long-term problems.
Update (hat tip commenter badmax): many Russians already took their money out before the capital controls were imposed.
Euros don’t flow into and out of Cyprus effortlessly anymore, so the so-called monetary union has been broken. Depending on how quickly those rules are removed, and how quickly Cyprus comes up with other things to do, this could be a huge problem for the country.
Take-aways
- What’s become blatantly clear by following this process is that there is no actual process. Things are being made up as they go along by a bunch of economists and finance ministers. A lot of faith in their abilities was lost permanently when they hatched plan #1 which was so obviously stupid.
- Going back to that stupid plan, whereby normal depositors were supposed to pay for the mistakes of banks at the expense of their insured deposits. It was so bald-faced that the citizens rebelled, and politicians listened. So just to be clear, there has been actual input by average people in this process. The economists and finance ministers have lost face and the people have found a voice.
- This is not to say that the Cyprus people are sitting pretty. They are not, and by some estimates the economy of Cyprus is poised to contract by 20%. This may lead to more bailouts or Cyprus leaving the Eurozone for good.
mathbabe 
Very well written, love reading your blog!
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Thanks!
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“Can I open 15 Bank of America accounts, each with $250K and so FDIC-insured?”
No, but you can open 15 accounts at 15 different banks with $249k in each and there’s an existing service that for a small fee (1-2bps? not much) will take your large sum of deposit cash and do the paperwork to execute exactly that for you. Impact is that very large deposits get spread around beyond the big banks to the regionals and even the mid-size banks.
..which makes me wonder, after Landesbanki hosed its UK and Dutch depositors, what prudent person has been keeping large sums of money on deposit in a Cypriat bank?
FoW
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I’ve already read reports of people pulling their money from Cyprus banks right before this went down. A kind of insider trading for IMF actions.
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At say, BofA, you can open an account in your name, another in your spouse’s name, another that’s held jointly and if you really want to push this you can I think open revocable trust accounts in your kid’s names. Personally I wouldn’t & didn’t as it concentrates too much risk in one place. So I closed our BofA accounts and put our savings into three credit unions and our cash accounts at a locally-owned bank. And I don’t trust the $250K FDIC limit, either, we have <$100K in any institution at any given time.
BTW I really enjoy your writing even if from time to time my eyes start to glaze over… Thanks for your blog, you're a daily read.
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Careful–as I understand it, the Joint doesn’t expand your 250 FDIC, it’s just split 50/50 between the joint account holders. So if I have $200 in an individual account and another $200 in joint account with spouse I’m exposed on $50k (200+ 1/2*200=300 > 250).
FoW
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I am not so sure that the transition costs of a good plan are “problems.” They are simply transition costs. They may be unfortunate effects but calling them “problems” makes it sound (to me) as though it’s a problem with the plan itself. If a financial sector is too large and poorly managed and it has to “clear,” then so be it. Maybe I am splitting hairs but I don’t see the unfortunate effects and transition costs as problems of the plan itself.
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Agreed, that’s why I point out they are transition costs. In fact I’m planning to write another post about “problems versus transition costs”. But maybe I can think of a sexier title than that.
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Sexier than that??? Oh, go on.
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Some of the Cypriot banks had subsidiaries in different countries that were unaffected by the restrictions up until capital controls were implemented a few days ago. Any Russian oligarch could walk right into the Moscow branch and withdraw his millions while the people in Cyprus couldn’t even use an ATM.
I think they’re in for a rude, painful surprise when they tally up what’s left of the uninsured deposits they’re planning to steal, er, “bail-in”.
http://www.zerohedge.com/news/2013-03-28/cyprus-answer-uniastrum
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That’s so fucked up.
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Probably true, but so far…ZeroHedge is the only source on this. I’d take it with a grain of salt.
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Reuters had the story as well.
http://www.reuters.com/article/2013/03/25/us-eurozone-cyprus-muddle-insight-idUSBRE92O0TM20130325
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Salt free?
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Rather than the briefcase, it seems there has been a lot of interest in bitcoin since the Cyprus situation unfolded. bitcoin charts has quite the hockey stick starting on March 18th across all currencies.
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Yeah I heard. I gotta look into that.
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While I get the feeling that there’s a bit here to covering his tracks, the Free Exchange blog over at the Economist gets a bit of an inside scoop on how things got this way with the former Cyprus Central Bank Governor:
“Athanasios Orphanides was governor of the Central Bank of Cyprus from 2007 to 2012, giving him a seat on the European Central Bank’s governing council and oversight of Cyprus’ banks. In an interview with The Economist, Mr Orphanides gives his views on how the crisis came about: exposure to Greece and the global financial crisis; decisions by the former communist government (with whom Mr Orphanides had a strained relationship); and flawed decisions by Europe’s governments. Mr Orphanides was raised in Cyprus, received his PhD in economics from the Massachusetts Institute of Technology and was an adviser at the Federal Reserve Board. He is now a lecturer at MIT and a fellow at the Center for Financial Studies at the Goethe University of Frankfurt. ”
http://www.economist.com/blogs/freeexchange/2013/03/interview-athanasios-orphanides
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Orphanides’ writings should be taken with a largish grain of salt: He left his post in disgrace when the government of the day (which he now slams in his Economist blog) refused to reappoint him on account of him peddling partisan political nonsense from the central bank.
– Jake
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Yeah, I tried to qualify the source, but he does make some factual claims to the timing and other reasoning to what was going on. I don’t think the whole story is quite as simple as “the banks invested heavily in Greece and when that imploded, so did their balance sheets” or something similar. And he at least gives some statements whose veracity somebody with luck and pluck (and some time) could evaluate.
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Merrill Lynch, now a division of Bank of America, had a program which would automatically shuffle your money around into different banks so that you were always under the $100,000 limit. I think they set this up in the early 90s in response to one crisis or another. (If I remember correctly, you can have two accounts in your name covered by the FDIC at a single institution if one is on each side of the IRA tax deferral wall.)
Once capital controls move into place and start getting enforced, Cyprus will have left the euro zone. Suppose you run a business in Cyprus and want to buy some asset in France that costs some non-trivial amount. You can’t just wire the euros from your Cyprus account, but you might find someone who would be willing to accept a certain number of blocked euros in Cyprus in exchange for some smaller number of unblocked euros in France. So, for E250,000, you could buy that E180,000 metal working machine or modest farmhouse in the Dordogne. There is effectively an exchange rate. I suppose they could outlaw that kind of transaction, but can’t imagine how they would enforce it in any meaningful way. Worse, I can’t figure out how they’d unwind a de facto exchange rate when they are ready to remove capital controls.
The euro as part of a monetary unification without a political unification was a stupid idea. A lot of people said so back in the early ’90s when they created the euro. It’s impossible to set an economic policy that optimizes a currency for more than a few cities or regions at a time. It’s one thing if all those cities or regions are in the same country, but if they are in different sovereigns, things are going to fall apart. You’d think the Germans would be sick of being the strong man, economically, of Europe. They had to carry East Germany through its unification, and now they are stuck carrying the European periphery. We’ll see if Merkel hangs on.
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Hi Cathy,
I’m a business school student with an interview soon and for the life of me I can’t find an article online detailing exactly what happened with the whole Cyprus crisis! I loved your post and was hoping whether you could critique my summary of it:
1) Russian lenders funneling money into Cyprus because of lower tax rates.
2) Cyprus banks investing stupidly into Greek bonds that defaulted.
3) Plan 1 was proposed, people were like wtf no, plan 2 was imposed.
4) Money gone and now needed a bailout from EU (which they got).
I keep thinking this isn’t very accurate. Is there any way at all for you to explain it to me a bit more clearly? I’m not very finance savvy but I want to learn! Please contact me by email or you can just reply here!
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Couple of issues with that. In order of severity:
First, the Greek bond holdings weren’t stupid at all when they were made: The Cypriot banks have a lot of Greek depositors and other creditors. Holding Greek tsys absolutely made sense.
What Cyprus (legitimately) couldn’t foresee was that the ECB would be staffed by insane Austrian idiots who were prepared to destroy the European clearing system rather than engage in unrestricted, unconditional and unlimited open market operations to defend a yield ceiling on European treasuries.
The Cypriots also feel – in my view justified – resentment that Germany and the other Austeritarian countries are not making them whole for their losses on Greek bonds, because Cyprus could (and should, in any rational universe) have vetoed the Greek private sector haircuts that are now a problem for Cyprus (or at least made them conditional upon Deutche Bank and the Bundesbank shouldering equivalent burdens).
Second, the Russian money isn’t there because of secrecy or low taxes – there are plenty of “better” jurisdictions for that. The Russian money is there because Cyprus (a) is an Orthodox country, which makes it more familiar to Russians in a number of ways, (b) because Cyprus and Russia have a number of arrangements making it easy for citizens of one to bank in the other and, crucially, (c) because Russia has, in the past, shown less tendency to arbitrarily confiscate the funds of Russians when they were deposited in foreign banks.
Finally, you need to go back much farther to find the root cause of the crisis. The Russian and Greek connections are spin and distractions from the core story of Germany pushing the unemployment cost of defending Germany’s dead-end economic policies onto Germany’s trading partners.
The story goes more like this:
1) Germany suppresses wages in order to make someone who is not the Bundesbank pay the cost of defending the Bundesbank’s hard-money, low-inflation, strong-exchange-rate policy.
2) German wage suppression causes a deficit of aggregate demand in the European Exchange Rate Mechanism (later the EMU), giving other European countries the choice between wage suppression and mass unemployment (as Holland, Finland and Denmark did), accepting structural current account deficits (as France, Spain, Cyprus, Greece, Italy, Ireland, Portugal and Malta did), or dropping out of the ERM/EMU (as Britain and Sweden did).
3) Cyprus’ structural current account deficits make Cyprus a net debtor.
4) The ECB states unequivocally that it will not monetize Eurozone government bonds, unless the victim country submits to idiotic conditionalities which will reliably destroy the real economy.
5) Net intra-Eurozone debtors lose access to the international money markets, because bondholders realize (correctly) that funding conditioned upon idiotic, self-defeating conditionalities is not sustainable.
6) Cyprus blows up.
7) Our Dear Leaders run around like headless chickens for a bit, demonstrating to all and sundry that they have no idea what’s going on, no contingency plans, and absolutely no intention to force the ECB to do its job and monetize the necessary unrestricted, unconditional fiscal defense of full employment.
You will notice that this is precisely the same fundamental story as in Greece, Spain, Portugal, Ireland, Italy and France. This is not a coincidence: This entire €-zone crisis is due to the idiocy of having a currency zone with no employer, lender, investor and borrower of first and last resort, who can engage in unlimited, unrestricted and unconditional fiscal expansion of any magnitude necessary to defend macroeconomic objectives.
– Jake
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