Yesterday, the head of the EU group of finance ministers dropped a bombshell on markets. Cyprus, noted Jeroen Dijsselbloem, was the new model for bank bailouts in the eurozone--which is to say, there won't be any. If your bank goes under, the intervention will be minimal. Depositors and shareholders will take substantial losses.
Markets, as you may imagine, did not like this news. European indices like the DAX plummeted. The euro dropped 1% against the US dollar. Would a bank run spread across europe as depositors in the periphery started to seek safer havens?
So far, no. Dijsselbloem's comments were quickly walked back, though not all that far: each situation is unique, said the EU, and there is no one model for banking crises. Unsaid: "We will bail out your banks if they get into trouble." Morgan Stanley analysts quoted in the FT say that "We now expect the downside risks for the euro to increase, given the apparent change in policy approach being adopted by the EU for bailing out the Cypriot banks."
All this has a curiously familiar ring. Five years ago, when the government bailed out Bear Stearns, we heard a lot about moral hazard. Lots of commentators, including, er, me, were worried that the Bear Stearns bailout would encourage bankers and other investors to take unwise risks with their money, because hey, if everything goes south, Uncle Sugar will pay the piper.
And so we heard a lot of tough talk from Treasury about how next time, there wasn't going to be any bailout. Treasury and the Fed spent long months preparing contingency plans for a major bank failure, and went into Lehmann determined that there would not be any US government money injected into a deal. They almost succeeded, too--as Lehmann tottered along towards the bankruptcy court, they got the other major banks to agree to buy a "bank bank" composed of Lehman's risky, toxic assets, as long as Barclay's bought the rest. If British regulators hadn't put the kibosh on the deal, their plan just might have worked.
But it didn't, and in extremis, the government refused to step in. Lehmann Brothers was allowed to fail. Two weeks later, the FDIC seized Washington Mutual and wiped out the bondholders.
. . . and everything fell apart. I don't need to rehearse the convulsions that followed the attempts to crack down on moral hazard in the middle of a financial crisis; they were dramatic and devastating. There were runs on the money markets, massive sell-offs on the stock exchanges, fire sales of virtually every asset except treasury bonds. The US financial system was melting down, and regulators realized that they couldn't stop the forces of chaos roaring down Wall Street with the unyielding ferocity of their steely gaze. And so, they blinked. They put together hundreds of billions of dollars worth of rescue funding and slapped a bank-style guarantee on money market mutual funds.
Is Dijsselbloem's statement any more credible than Hank Paulson's assurances that he would not bail out another financial institution?
It's easy to talk big after Cyprus. The total amount needed to bail out the whole island is a rounding error in the gross domestic product of the other eurozone nations. The only reason anyone worries about Cyprus (I mean, aside from the Cypriots and the unfortunate Russians who stored money there) is that it might be a barometer for future EU policy. Presumably because it's so small, markets accepted the Cypriot deal rather gracefully, which was welcome, but not an enormous surprise.
Markets will not be so sanguine if it is the Spanish or Italian banking system that needs an infusion. Luckily, their banking systems are much less likely to have a crisis of this magnitude. But if that crisis does come, it won't matter what Djisselbloem said yesterday--or what finance ministers are telling each other. What will matter is how they feel if and when the markets come crashing down around their ears. And just as there are few atheists in foxholes, there don't seem to be many moral-hazard-hawks in a financial crisis.