The Cypriot banking system is insolvent; it needs a large capital injection. As in several other peripheral states of the Eurozone, Cyprus cannot resolve the crisis alone. Given an already high debt-to-GDP ratio and an oversized banking system, recapitalising the banks via sovereign debt would produce unsustainable sovereign-debt levels and, ultimately, sovereign default. In short, Cyprus’s banks are too big to fail, and too big to save.

This is why Cyprus negotiated a rescue package with the Troika – ECB, European Commission and IMF. The 'bailout' agreement (in quotation marks, as it is not quite sure who is supposed to be bailed out here, certainly not Cypriot taxpayers and their children, to be burdened with debt for a long time) is still in the making and might even fall through. The damage, however, has already been done. There has been a complete loss of confidence, not only in the Cypriot banking system but also in the crisis-management capacity of the Eurozone.

The Saturday morning hangover

The decision taken in the early hours of last Saturday caused indignation and rejection across Europe, and rightly so. While imposing market discipline is a useful aim, and long overdue after four years of bailouts at the expense of taxpayers and future generations, the way it was originally to be imposed in the case of Cyprus has been more than counter-productive.

Economists and practitioners alike point to a couple of common principles in bank resolution. One is respect for creditor ranking:

• Equity holders take a hit before junior debt holders;


• Junior debt holders take a hit before senior creditors and uninsured depositors.


• Insured depositors should take a hit last.

Such a creditor ranking is based not only on legal rules, but also on the idea that claims should be priced according to their risk and expected repayment in case of failure.

The 'bailout' deal with Cyprus foresees, however, a tax on deposits, originally imposed on all deposits even those covered by the EU-wide deposit insurance. Put differently, insured depositors suffer a haircut, while uninsured depositors still maintain a large share of their claims. This seems a violation of the creditor ranking, in spirit if not in the letter of the law.

In order to not violate the promise of deposit insurance of up to 100,000 euros, what the agreement calls a tax is effectively an insurance co-payment. There is nothing to be said against co-insurance, which can improve market discipline, but introducing it ex-post constitutes a clear violation of trust. And if it walks like a duck and it quacks like a duck, let’s call it a duck! This is not a tax, but an ex-post insurance co-payment and loss-sharing arrangement.

But there is more. Imposing losses on depositors is to be done in order to reduce the risk of sovereign over-indebtedness and thus guarantee repayment of current sovereign-bond holders. Imposing losses on insured bank depositors to thus guarantee repayments to sovereign-bond holders violates another political priority of putting (certainly more sophisticated) bond holders above (mostly less sophisticated) holders of small deposits.

Finally, imposing a tax on depositors of all banks, independent of the financial situation of each bank, further undermines market discipline. Yes, it seems an easier option, requiring less administrative effort, but it sends the message that investors do not have to price investments properly as the haircut is the same across banks. And it increases herding trends towards aggressive risk-taking.

Addressing the problem at its core

The Cypriot economy is in crisis, for many reasons. But the insolvency of the banking system is at the core of the current crisis, and should therefore be the focus of the resolution. The literature on resolving bank crises has pointed to several important lessons. On is that losses should be recognised early on, allocated and then managed. While the flow solution, i.e. re-establishing solvency of the banking system through retained earnings or future government earnings, seems attractive as it avoids immediate pain, it comes at high risks.

Financing recapitalisation out of future taxes and expected privatisation gains is also counterproductive as it ties banks and governments together yet again. Fiscal tightening will lead to an increase in non-performing assets in the banking system. Unless banks are properly recapitalised, they will not be able to support the private sector and the economy in its attempt to grow out of the crisis, which in turn undermines government finances.

Finally, tying banks and governments together creates expectations that more adjustments and possible write-downs might be ahead. There is a tendency in such circumstances to under-estimate losses and overestimate future revenues, as the Greek case has clearly shown.

As so often before, the 'bailout' agreement has caused more trouble than solved problems. Rather than disentangling banking and sovereign-debt crisis, it has tied them again together, by shifting bank insolvency to sovereign-debt insolvency.

Hello Iceland!

Iceland was vilified in 2008 for allowing its banks to fail, transferring domestic deposits into good banks and leaving foreign deposits and other claims and bad assets in the original banks, to be resolved over time. On the other hand, the Icelandic government kept its fiscal house in order and maintained an investment grade for its bonds throughout the crisis. Iceland’s economy has recovered building on industries other than banks for renewed growth, even though Iceland’s society is still suffering from the traumatic events of 2008. And while mistakes might have been in the resolution process (Danielsson, 2011), Iceland’s banking sector does not drag down Iceland’s growth any longer and might eventually even make a positive contribution.

What can we learn from Iceland? Unlike Cyprus it is outside the Eurozone, so it was politically and legally easier for it to allow its banks to fail. The bank failures, however, had ripple effects throughout the globe given the rapid international expansion of Icelandic banks both in deposit collection and asset markets. Such ripple effects might be actually lower in the case of a systemic Cypriotic bank failure. Most importantly, Iceland’s experience 'ended in horror' rather than led to the 'horror without end' that Greece has been living through over the past four years and that Cyprus is now facing for years to come. The Icelandic approach of recognising losses, allocating them and moving on might not be easily replicable, but it certainly shows that there is an alternative to the approach that the Eurozone has been taking over the past four years! And as I will argue below, probably the only solution for Cyprus at this late stage of the game.

Quo vadis, banking union?

The Cypriot crisis has revived the Eurozone crisis, though many observers doubted that it had ever gone quiet. And it resurrects questions about:

• What would have been different under a functioning banking union and;


• What this crisis means for the future of the banking union.

The Cypriot crisis has underlined again the urgent need for a Eurozone-wide approach to bank resolution. It also underlines, however, that simply supervising banks on the Eurozone level is not sufficient.

The gaps in Cypriot banks’ balance sheets have been known for a long time (even if probably not in its whole extent), but it is the resolution of these banks and the funding of the resolution that is critical and goes beyond the capacity of the Cypriot government. And even though the solvency gap has been known for a long time, forbearance on the national level (linked to the political situation) has made a bad situation worse.
But there is no banking union in place.

• 'Bailing out' Cypriot banks with loans from the ESM is not an option as this will turn the debt-to-GDP ratio in Cyprus unsustainable.

So, what else?

• The only way seems to be a recapitalisation of Cypriot banks directly by the ESM.


• This is tough since there is no appetite in northern Europe to pour money into the oversized Cypriot banking system.


• This reinforces the call for a European Resolution Agency to take over these banks, wipe out equity holders claims and recapitalise them, with profits eventually going back to the ESM.

Looking at the issue from a different perspective, the Cypriot crisis has shown that the resolution of the current Eurozone crisis cannot wait and should not depend on the construction of the banking union.

To construct a functioning banking union, without which the Eurozone is not a sustainable currency union, is a longer-term process. The crisis in Cyprus cannot wait for the banking union. As suggested in a previous column (Beck, Gros and Schoenmaker, 2013), the current crisis calls for the establishment of an asset-management company or European Recapitalisation Agency, which would sort out fragile banks across Europe, both small and large, with strongly capitalised banks allowed to go ahead and weak banks either being recapitalised or (partly) liquidated. Where possible, banks should be recapitalised through the market; if not feasible, the resolution authority recapitalises by taking an equity stake in the bank (by straight equity or hybrid securities).

And the politics …

A lot has been written about the bad idea of forcing losses upon insured depositors (Wyplosz 2013 ). But there is an increasingly clear picture that it might not have been creditor countries or the Troika who came up with this idea, but maybe the Cypriot government itself in order to avoid imposing losses on large (and thus most likely) richer and more connected depositors. Which is yet another indication of how closely politics and finance can be interconnected, with strong though opaque lobbying power of the oversized banking industry.

The failure of the Cypriot banking system also shows yet again the risks of financial centres in small economies, i.e. the idea of the financial sector as an export sector, i.e. one that seeks to build a nationally centred financial-centre stronghold based on relative comparative advantages such as skill base, favourable regulatory policies, subsidies, etc. As recent research (Beck, Degryse and Kneer 2013) has shown, a large financial system might stimulate growth in the short term, but comes at the expense of higher volatility. It is the financial-intermediation function of finance that helps improve growth prospects, not a large financial centre, a lesson that Cyprus could have learned from Iceland.

Looking forward

Cypriot banks urgently need restructuring, but so does its economy more generally. The economic model based on an oversized financial centre has failed, but a functioning financial system is necessary to handle its economic transformation to a new model.

• Splitting the Cypriot banking system into a bad ‘legacy’ part and a good forward-looking part seems the only feasible and effective solution to resolve the current crisis and restore trust.

It is not an easy solution, but certainly more promising than the proposals being discussed in Nicosia and Brussels, which will just extend misery and deepen the crisis further.

If Europe is to help, it should be by helping to resolve a broken banking system, not just by providing resources but by actively helping in the resolution process. Doing so would be a true signal of European solidarity and a first step out of the Eurozone crisis.

*The article was originally published in www.voxeu.org.

References

Beck, Thorsten, Daniel Gros, Dirk Schoenmaker (2012), "Banking union instead of Eurobonds – disentangling sovereign and banking crises", VoxEU.org, 24 June.

Beck, Thorsten, Hans Degryse and Christiane Kneer (2013), "Is More Finance Better? Disentangling Intermediation and Size Effects of Financial Systems", Journal of Financial Stability, forthcoming.

Danielsson, Jon (2011), "How not to resolve a banking crisis: Learning from Iceland’s mistakes",  VoxEU.org, 26 November.

Wyplosz, Charles (2013), "Cyprus: The next blunder", VoxEU.org, 18 March.