Cyprus to Small Depositors: We Won't Take Quite So Much of Your Money

Cyprus seems to have realized what I wrote yesterday: violating your deposit insurance guarantees is a better way to start a bank run than to stabilize a banking crisis. After Cypriots rushed to withdraw their money ahead of the new rules, the Wall Street Journal reports that the government has cobbled together a new proposal: small depositors will pay a 3% "tax" on their accounts (instead of 6.75%); medium depositors (those with between €100,000 and €500,000 will be taxed at the same 10% they were supposed to pay before; and those with more than €500,000 will pay 15%.

That may check the runs on the small accounts. Now the question is: what about the big ones? Will the foreign depositors view 15% as the simple cost of stashing their money out of the watchful eye of their own government? Or will they seek a new haven?

If the foreign money runs, it seems unlikely that Cyprus will be able to bail out the banks again; this desperate bank levy is, after all, what they were forced to do just to raise the $5.8 billion that the EU and the IMF demanded they contribute to the bank rescue. But the higher Cyprus raises the levy on large accounts, the more likely it is that the foreign money will flee to somewhere less shaky.

It may already be too late for Cyprus. Government guarantees are a powerful tool for fighting banking crisis, but only if they're credible. Once you've suggested that you might be willing to let people lose a lot of money, you've irrecoverably squandered a lot of that credibility. The time to stop this bank run was before it started.

Unfortunately, that's no longer an option. So all we can do is wait and see . . . and hope that if Cyprus does go down, it doesn't take the rest of the European banking system with it. In many European countries, the banking system is several times larger than the country's GDP (in the US, the ratio is closer to one-to-one). Which means that many countries are potentially vulnerable to a run, because in extremis, their governments could not possibly provide enough money to bail out the whole system. As long as people think that they have deposit insurance and other implicit government guarantees, the banks are good . . . but if push actually comes to shove, and things get really bad, they will not be able to step in and do what the US government did in 2008, writing checks large enough to actually quel the panic.