Four lessons from Cyprus's financial crisis
On this day 10 years ago, at 4 a.m., I checked my twitter messages and realised that a bail in of all deposits, including insured ones, was agreed in Brussels.
By the time I managed to get to the ATM, there was already a queue forming. Bank employees would walk past us looking perplexed. When those same employees realised that they were locked out of their systems, panic set in. Cyprus’s banking system remained closed for 18 days, bringing the whole economy close to collapse.
The initial agreement of a 6.75 percent haircut on insured deposits (below 100,000 euros) and 9.9 percent on uninsured deposits was rejected by the Cypriot parliament. In the end, 9.4 billion euros of just the uninsured deposits (as well as bonds) at the country’s two biggest banks were bailed in to recapitalise them.
Not all banks inflicted losses on depositors. The cooperative system, which was until then a loose network of credit unions, received 1.5 billion euros of taxpayer money to recapitalise and centralise under the Cooperative Central Bank.
Ten years on, what have we learned from the experience?
1) Procrastination turned a bail-in into the least-bad option
Cyprus’s outgoing government, under then-President Demetris Christofias, refused to admit that both its budget deficit, and the pending bank recapitalisation, necessitated the unpalatable act of requesting financial support from the rest of the euro area and the International Monetary Fund.
The foot-dragging destroyed any other bailout options, while dramatically increasing the cost recapitalising the banks. By the time the bail-in was agreed by the new president, Nicos Anastasiades, Laiki bank had already faced substantial withdrawals and was relying on Emergency Liquidity Assistance — the ECB’s credit line of last resort — to the tune of 9.9 billion euros.
The bail-in of uninsured deposits reduced the overall size of the financial package Cyprus needed. This allowed Cyprus to avoid piling on even more national debt, that had led to the spiral of austerity and economic contraction Greece faced after its first two bailout programmes.
By the time Cyprus asked for assistance, the bail-in was the least bad option left on the table.
Gross domestic product dropped 9.3 percent in real terms by 2014, but the recovery was robust after that. By 2016, GDP was already above its 2012 level, and Cyprus exited its bailout programme. In the end, Cyprus only ended up using three quarters of the 10 billion euros that was available in the bailout package.
2) The bail-in was bungled, causing needless economic damage
The bail-in may have been the least bad option left on the table, but the way all stakeholders handled it caused huge economic damage.
The initial plan agreed on March 15 was not liked by anyone. European bodies were uncomfortable with the idea that insured deposits would be haircut, as they feared contagion in other weak European states. It was disliked in Nicosia too. In Makarios Drousiotis’ book, Summoria, the author, using Cypriot government sources, suggests that the bail-in of deposits was so unpopular that Anastasiades engineered its failure in parliament so as to replace it with a plan to bail in all pension funds on the island.
Parliament did reject the initial scheme — leading to a frantic period with the banks closed — until a new plan was agreed on March 25 that bailed in the majority of the uninsured deposits and merged the two failed banks, Laiki and Bank of Cyprus. The bail-in — which it had been estimated would take 7 billion euros from depositors and bondholders — ended up coming to 9.4 billion euros as a result of its chaotic nature.
Even that amount hides the true damage to the banking sector. The reconstituted Bank of Cyprus, Hellenic Bank and the Cooperative Central Bank all needed to raise more capital within two years of the 2013 events.
European policy makers also didn’t want to provide additional funding to create a “bad bank” that would allow Cypriot lenders to offload their non-preforming loans. As a result, the banks remained saddled with the bad loans, selling them to distressed debt funds at a far steeper discounts. Yet experience in Ireland — and even Cyprus itself after the collapse of the Cooperative Central Bank — has demonstrated the benefits of bad banks, which allow lenders to recover faster and let the state recoup some of the money put up by taxpayers.
Trust is an essential part of maintaining a modern economy. The cost of the erosion of trust is hard to model and predict, but it can be pervasive. Lessons from Cyprus indicate that the breach of trust in 2013 still has negative impacts for the economy even to this day, with low savings being one problem.
The bail-in failed to stabilise the banking system. Cyprus has had three bank failures since 2013 — although not all of them for the same reasons.
Also, if the bail-in was a way to reduce the power of Russian oligarchs, it was a complete failure. Turning depositors into owners of the banks increased the power and leverage of Russian interests, rather than reduce it. What did eventually reduce Russian influence was the stringent application of due diligence rules, but that had far more to do with U.S. threats than the bail-in.
3) The deposit insurance limit is fiction
One of the things that Cyprus shows is that bailing in uninsured depositors is the exception and will never be the rule no matter what directives or regulations say. In the latest bank failure, that of SVB, the Biden administration came out on Sunday evening and guaranteed all deposits, including those above the $250,000 insured limit.
There is no politician in the world who is willing to take the political cost of a bail-in, even if that is the least bad option. In the case of Cyprus, the government and parliament only accepted the bail-in of uninsured deposits after two weeks of the economy being on its knees due to the closure of the banking sector. Following the collapse of the Cooperative Central Bank, Anstastiades preferred to saddle the state with a cost of about 4 billion euros to eliminate any possibility of a new bail-in.
4) There is no such thing as a “creditless recovery”
In 2015, the IMF announced its confidence that Cypriot economic recovery would continue despite the inability of banks to provide substantial credit. However, this was not exactly true. Although credit from banks was limited, Cyprus, and in particular its real estate sector, saw an influx of at least 9 billion euros from its Citizenship by Investment scheme. In the beginning, there were those in the EU who looked favourably at the scheme as a way of reducing the amount of continued support Cyprus would need. However, that scheme created a whole range of other problems for the EU, some of which it is still having to deal with today.