Spurious Data

Is Cyprus Europe’s Lehman?

During the summer of 2008 when Lehman began to have trouble, it was offered a lifeline; a loan from Warren Buffet that Lehman CEO Dick Fuld thought was too punitive. When Lehman’s troubles became life threatening a weekend meeting with a brokered merger proved unsuccessful.  The US was able to merge Bear Stearns with JPMorgan; Bear did not go bankrupt. But Lehman was different, a “lesson” that we could not have an institution that was too big to fail. We all remember, chaos ensued and the government finally passed the TARP plan to shore up banks and financial institutions.  Today we are still left with a Too Big to Fail subsidy in the United States.

Now on to Europe and Cyprus where we see many parallels.  Cypriot banks, though achieving high marks in the ECB stress tests, were reliant on the ELA loans to finance themselves. They were not able to issue debt in the market and there are very few senior bondholders to stick with the restructuring bill.  Thus the troika came up with what it thought was an elegant solution: a cash for equity swap with depositors. The Troika would tax depositors now in exchange for bank warrants and equity later if deposits were left in each respective institution. It was treated in the US press as a confiscatory tax but in continental Europe, and amongst Italians and Spaniards in particular the move was considered fair.  After all, depositors in Cypriot banks, especially the 40% that were foreign depositors received high interest rates and low taxes for years.   Those foreigners that set up businesses in Cyprus were avoiding taxes in their home countries, some legally, some illegally.

There was an almost schadenfreude-like glee from the core of Europe, the tax evaders were now seeing the inevitable outcome from their folly (Cypriot banks payed high interest rates but built on subsidized ELA financing) yet when it came time to vote on the measure in Cyprus’ parliament, it was an impossible sell.  This was no surprise to those watching the twitterverse where there was a large amount of skepticism and a great concern for contagion and pending collapse of the Eurozone as we know it.  Two caught our attention,  “will the Cyprus experience be seen as a test run for what it is like to leave the euro?[1]” and “protesters tear down German flag from German embassy in Cyprus.[2]

Enter the Russian element. The reason Cyprus is considered different from the core is not just because of its outsized banking sector in proportion to its economy (8 times); after all, Iceland and Ireland had large banking sectors too.  It is because Cyprus was a haven for Russian deposits due to a tax treaty with Russia going back to the early 90s when Glasnost and Perestroika were sowing the seeds of reform. Much of the early money leaving Russia was linked to organized crime or ill-gotten gains. Some of the deposits were from asset managers wanting to avoid capital gains tax in Russia. Some of the deposits were from Russian entrepreneurs who knew they had a better chance of success with a lower tax regime. But many of the deposits were perceived by the Europeans as dirty, or shall we say, clean, newly laundered money.  The amount of money passing between Cypriot and Russian financial institutions was exceedingly large for the absolute size of Russian deposits in the system, indicating there was a money laundering aspect to much of the Russian banking in Cyprus.  Without going into all of the details, (some can be found on this link to the OECD the point is that the perception amongst the core Europeans, and the Germans especially and the SPD in particular is that Cyprus was a haven for dodgy Russian money. This was not something German taxpayers would support and with upcoming German elections in September, what the German taxpayer will and will not support is critical. It is important to keep this in mind should another country need assistance before the end of September.

So, while we can see that Cyprus has many one-off characteristics, it is part of a larger set of problems and it comes after Ireland and Greece and possibly before Spain, Italy, Slovakia or Hungary.  Europe has yet to answer the question how does the Eurozone handle mismanaged balance sheets without destroying prospects for economic growth? The Greek pseudo-default last year shines light on the delicate balance that has yet to be achieved by European officials. On one hand, it would have been a viable option for Greece to have exited the Euro, devalue its currency, and inflate its way out of its debt problem. On the other hand, had the Grexit occurred, it would have impacted many German banks and it would have cost the German taxpayer more in the end.  Not so with Cyprus, or so the current logic goes.

Cyprus is not only smaller than Greece, but by many orders of magnitude. The Î5.8bn that the bank tax would cover is a mere 0.06% of the annual EU GDP. But Cyprus does not owe money to the core. Core institutions do not have much known exposure to its banks. Core institutions do not have significant two-way transactions with Cyprus. The perception is it is only Russia that has two-way transactions with Cyprus.

Against this backdrop the unthinkable has come to pass. The ECB issued an ultimatum, ‘come up with the EUR 5.8bn or we will cut you off from ELA funding’.  If this happens Cypriot banks will cease to have sufficient capital and the country will likely leave the Eurozone. The depositors who balked at a cash for equity swap (9.9% for accounts greater than EUR100,000 and 6.7% for smaller accounts) could well suffer the fate of the Lehman creditors if the ECB cuts them off. Those with deposits above the EUR100,00 insurable level will be locked in a five-year plus battle to recover their assets and they will receive maybe  40 or 50 cents on the dollar, – far worse fate than the tax scheme.  Yet one can understand why the parliament voted down the scheme. In its original conception it was not nearly progressive enough. It punished ordinary Cypriots too much and it had more than a whiff of German imperialism.

This brings us back to our Lehman analogy. Lehman was considered too small and not systemic enough to cause problems and given Fuld’s recalcitrance, it made sense to make an example of Lehman. The CEO had not made friends of his fellow CEOs on Wall Street nor with those at the Fed or in DC.  He was not quite as disliked as Russia is by Europeans, but he was similarly distrusted.  We all know the Lehman failure proved chaotic in its aftermath.  We also know that its failure has not solved the perception that certain banks or institutions are too big to fail. In fact, at the same time Lehman was allowed to fail, AIG was given assistance.

Might a similar trajectory be seen in Europe? Allowing Bank of Cyprus and Laiki Bank to fail would surely cause a deep economic contraction in Cyprus. For those with deposits under EUR100,000 they will presumably receive the deposit insurance. For those with deposits greater than EUR100,000 it would mean heavy losses for Cypriots and foreign depositors alike. The tide will go out and we will see who else is swimming naked. Economic and financial market chaos may well ensue in Europe. It may be a Core EZ bank or financial institution or it may be in a country such as Slovakia or Hungary and then we will get the real test if this is a one-off or not.

Cyprus is not the straw that will break the camel’s back, just like Lehman was not the end of Too Big to Fail. The real test will be the next bank or sovereign event. Europe does not have a pan-European mechanism to deal with bank failure and this was brought into stark relief with the Cyprus problem. Brussels recognized the need for one last summer, but like all things in Europe resolution was moving at a glacial pace. Yet without such a mechanism capital will not equalize between countries and economic union will be hampered, possibly even put in jeopardy.  The real test of the European project will come when a Spanish or Italian or possibly a Slovak or Hungarian institution or set of institutions requires assistance. Then we will see if the German taxpayer believes the full European Union is worth saving.



9 Responses to “Is Cyprus Europe’s Lehman?”

MikeleMarch 26th, 2013 at 6:10 am

The writer is really not democracy oriented person with stupid
and jellos arguments against russian money but at the end of the day that is not blood or narco money like in switzerland or elswere in Europe
My point is that unlike in USA who printing money to forgo to upstic economy Europeans have to split euro as not sustained artificial experiment
As for Germans,they should pay for weaker countries because only in artificial Eurozone they having Fourth Reickh
being again powerfull and prestigious

spiderMarch 26th, 2013 at 7:13 am

The writer is accurately describing things as they are – including perceptions about Russia which you don't like. She is not making moral judgments.

Be More SkepticalMarch 26th, 2013 at 10:10 am

If Europe wants to target Cypriot deposits because of money laundering, it should have placed Cyprus on the FATF blacklist. But, actually, Cyprus "substantially implemented" the international tax standard presented by the FATF – it was more rapid in complying, in fact, than Switzerland, Greece, Poland, the Czech Republic, Sweden, Finland, Iceland, Portugal, and Belgium. So how can you turn around and use laundering as a lynchpin when you already gave Cyprus the green light? Either the Germans are stupid, or their political leaders have no real support and routinely hand out these racist justifications simply because they have nothing better to offer.

jaimeMarch 27th, 2013 at 6:06 pm

"Be more skeptical" comment is very good. Last year, Argentina (of all countries!) denounced Uruguay for laundering Argentinian money… and Uruguay was punished and insulted by that dwarf (in body and mind) who, at the time, ruled in France. Now, Argentinians cross over to the closest Uruguayan port to pull dollars out of their accounts using ATMs. Some countries, such as Greece and Argentina, can always be relied upon to come up with immoral solutions to the economic problems they themselves created. Is Cyprus another such case?

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