Cyprus’s Emotionally Satisfying, But Likely Ineffective ‘Bail-in’
The Cyprus banking crisis is reminding us of a fundamental, much-neglected truth about finance, writes Daniel Gross: when you leave money in the bank, you’re the lender.
So Europe resolved—at least for now—the crisis in the Cyprus banking system. Needing a massive bailout, Cyprus on Monday opted for what’s known as a “bail-in.” In exchange for cash from the European Union, the European Central Bank and International Monetary Fund, Cyprus will raise several billion euros by assessing a levy on uninsured deposits of its large banks. CNBC has the details: accounts above 100,000 euros in the Popular Bank of Cyprus and the Bank of Cyprus will be assessed a levy (or tax, or confiscation) of 30 percent or more.
The relief was short-lived, as stocks around the world fell in response to the news. Why? Well, as we should have learned from five years of crisis management, the financial problems in Europe are never contained—especially when the relevant authorities say they are. More broadly, the “bail-in” is causing people to change the way they think about banks and the money they leave there. Indeed, Cyprus has forced us to relearn a fundamental truth that gets lost in the world of brands, 24-hour ATMS, catchphrases and goofy ads as banks compete feverishly for wallet-share. When you leave money in the bank, hoping to get a small return of interest, you’re not investing. You’re lending money. When push comes to shove, you’re not a customer of the bank. You’re a creditor. And these loans, like every other type of loan, can go bad.
When financial entities fail in the business world, the people who have made commitments to them suffer losses. Stockholders get less than they paid for their shares, and may wind up with nothing. Other stakeholders—the landlord who rents space to a store, the supplier who extended credit, workers with underfunded pensions, bondholders—settle for less than they were legally entitled to by contract. These “haircuts” take place all the time in and out of bankruptcy courts.
Now, in the U.S., and in most other places in the 21st century, the overwhelming majority of us “lend” to banks without consequence, and without fear of loss. In the U.S., the Federal Deposit Insurance Corporation’s will insure up to $250,000 of “loans’ made by a single customer to a single bank.
When your bank fails, as hundreds have in the last several years, the FDIC fund, which now contains $33 billion, steps up. And in 2008 and 2009, when it seemed as if the insurer would be overwhelmed by a tsunami of failure, the Federal Reserve and Treasury offered further guarantees. That’s how the U.S. prevented the Great Panic of 2008 from turning into the second coming of the Great Depression of the 1930s.
Regulatory orthodoxy in the U.S. and Europe has generally held that banks can’t be allowed simply to collapse because they are too interconnected and too leveraged. Lenders, it turns out, are prodigious borrowers themselves—banks borrow from one another, from the capital markets in the form of bonds, from central banks, and from depositors. When they fail to make good on their commitments, it triggers a host of failures and a chain reaction that effectively freezes economic activity. See: Lehman Brothers, September 2008. The investment bank owed more than $600 billion to other parties. Its plunge into bankruptcy caused the entire global financial system to go into a deep freeze.
In the U.S., when the system encounters trouble and asks for help, the answer is always yes, for better or worse. To fend off a global financial panic, U.S. authorities expanded their lending and guarantee activities beyond the banking center. In 2008 and 2009 the Federal Reserve controversially lent billions of dollars to AIG, which was an insurance company, so it could pay off financial obligations to other nonregulated banks. And despite the rising chorus calling for a new regulatory regime to bring an end to banks being “too big to fail,” it’s hard to see how it will ever be otherwise. Not while the memory of Lehman's fall is relatively fresh. And not while the political fallout of a failure to bail is greater than the political fallout of a bailout.
In Europe, by contrast, the answer is always … well, a bunch of summit meetings, brinksmanship, and statements, and then a halfhearted effort. In Europe, the people who have had the most to gain politically from saving their domestic financial systems—incumbent politicians in Greece, Ireland, Spain, and now, Cyprus—lack the financial firepower to carry out a bailout or institute new backstops. Meanwhile, the people who run the IMF, the European Central Bank, and Germany, which effectively control the financial-crisis-response efforts, don’t have anything to gain politically from stepping up.
Banking is complicated. But what happened in Cyprus was relatively simple. The banks borrowed way too much by accepting loads of deposits from Russian, British, and domestic customers. They then took the borrowed money and invested it in Greek bonds and in loans to customers around the Mediterranean and Adriatic. Apparently, few people in Europe understood that an outsized financial system, full of dark money, integrated with Greece, would fail in a way that would inflict harm on its lenders—i.e. its depositors. It is common to note that European elites seem to be playing checkers when they should be playing three-dimensional chess. But they’re not even playing checkers. They’re playing Tic-Tac-Toe.
The “bail in” is satisfying on some level. The Europeans are drawing a line at bailing out Russian oligarchs who park money in Cyprus. But it’s not going to stop the crisis in its tracks. When not treated properly, bank runs and financial panics often lead to depressions. In Greece, an ineffective policy response has turned a debt crisis into a six-year depression that has seen that country’s economy shrink by about 25 percent. Because it is moving to hurt one class of lenders (its bank depositors) to make another class of lenders (the IMF and European Central Bank) feel comfortable, Cyprus is about to embark on the same path.