Follow-Up: Further Program Notes For The Cyprus Banking Drama

Last Friday I sketched out some program notes for the Cyprus banking crisis. The notes explained the origin of the banks’ losses (Act 1) and the tools that regulators could choose from to resolve the crisis (Act 2). Now the curtain has gone up on Act 3. The government of Cyprus and the EU-ECB-IMF “Troika” have agreed on a resolution plan. By and large, it uses the familiar building blocks of past systemic bank restructurings, but it puts them together in some unusual ways. Here is a brief outline, based on numerous press reports circulating this morning:

Act 3, Scene 1: Liquidation of Laiki Bank
The country’s second largest bank, Laiki Bank, will be liquidated. Deposits over €100,000 will be transferred to a “bad bank” along with the bank’s portfolio of toxic assets, which include large amounts of Greek government bonds and nonperforming real estate loans. Shareholders of the bank will be wiped out, along with both senior and junior unsecured creditors. The large deposits will be frozen for the time being.

One way of understanding the bad bank would be to view it as a sort of mutual fund or investment trust, with the large shareholders as the involuntary investors. The trustees—in this case government regulators—are supposed to manage the assets in a way that will realize the maximum possible value, although that will certainly be far below the nominal value of the deposits. Eventually any residual will be paid out, with the large depositors taking a substantial, but as yet unspecified, haircut.

Small depositors in Laiki Bank will not be compensated by deposit insurance. The government of Cyprus does not have the funds to do so, and one insolvent party cannot bail out another. Instead, the small deposits will be transferred to the country’s largest commercial bank, the Bank of Cyprus. (See Scene 2.)

The claims of so called “trade creditors”—lawyers, accountants, and so on—will apparently be paid in full, as will claims of secured creditors, such as counterparties on repurchase agreements and derivatives. Short-term lender-of-last-resort loans from the European Central Bank will also be honored in full by making them liabilities of the Bank of Cyprus.

Act 3, Scene 2: Restructuring of Bank of Cyprus
The country’s largest bank, Bank of Cyprus, will remain in business. The bank’s own small depositors and those coming over from Laiki Bank will be able to access their funds, at least in part, as soon as banks reopen. Large depositors of Bank of Cyprus will not fare so well. They will find their funds frozen even after the bank opens its doors.

Technically, Bank of Cyprus is still solvent, although its capital has fallen below the minimum required by EU regulations. Many observers are convinced that a true accounting would reveal that the bank in fact has negative capital. In either case, it will need a large increase in its capital to survive. A surprising element of the restructuring plan is that apparently no EU or Cyprus government funds are to be used in the recapitalization.

Instead, the plan envisions recapitalizing the bank entirely through a reduction in its liabilities. (Remember that the capital of a bank is, by definition, equal to its assets minus its liabilities, so reducing the last while assets remain unchanged increases the first.) That will mean a severe haircut for large depositors and very likely a complete wipe-out of unsecured creditors.

It is not clear to me from this morning’s news reports exactly what will become of Bank of Cyprus’s current shareholders. Since the bank is being treated as solvent, and since it will stay in business, it appears that their shares will retain some value. It is likely, however, that new shares will be issued as compensation for large depositors and unsecured creditors. At least, that was one of the ideas that was under discussion last week. If that is done, the original shareholders have their claims on the bank extensively diluted.

One way or another, it is clear that there will be a massive bail-in of the large depositors, unsecured creditors and shareholders of Bank of Cypus. As in the case of Laiki Bank, it appears that the claims of trade creditors, secured counterparties, and the ECB will be protected.

Act 4: Intended Consequences, Unintended Consequences, and Collateral Damage
The liquidation of Laiki Bank and the restructuring of Bank of Cyprus will not be the end of the drama. Cyprus and the Eurozone as a whole will be the scene of a complex set of intended consequences, unintended consequences, and collateral damage for months and years to come.

One intended consequence of the restructuring plan is to assure small depositors that they will be made whole in the case of future bank failures anywhere in the Eurozone. Hopefully, that will prevent a breakout of bank runs in Spain, Italy, and other troubled EZ members. (That outcome would have been more strongly assured had EZ authorities not initially gone along with the ill-considered plan to subject small depositors in Cypriot banks to a 6.75 haircut, including even those in the country’s smaller, more solvent banks.)

A second intended consequence is to avoid the moral hazard that would have followed had the restructuring been carried out in a way that fully protected large depositors, unsecured creditors, and shareholders. In that respect, the resolution of the Cyprus crisis is a shot across the bows of too-big-to-fail banks everywhere. (Although Bank of Cyprus and Laiki Bank are not large by global standards, each of them has assets larger than the entire GDP of their home country.) I hope that U.S. bank regulators take note. Hey, guys, are you watching??? Probably not.

An unintended consequence of the events in Cyprus will be an increase in uncertainty for every kind of client and investor in EZ banks. The Cyprus restructuring plan has neither followed any set of rules, nor has it explicitly set any precedents. Until a full banking union is in place, it is likely that any future banking crises will be resolved in the same unpredictable, ad-hoc fashion. As James MacKintosh puts it in a blog post today on the web site of the Financial Times, “There are lots of lessons to take away, among them that Europe’s political leaders still have no idea what’s going on, and that banks are only as safe as their sovereign.”

Collateral damage will be extensive. A huge chunk of the Cypriot economy will simply disappear. Thousands of bank workers will lose their jobs, along with many others, down to and including the technicians who service the private jets of offshore depositors.

There will be collateral damage in Russia, too. Losses directly due to haircuts on offshore deposits will be only part of the problem. The loss of banking services will also damage many Russian businesses. Reportedly, some large Russian mergers and acquisitions are already on hold because the money for them was supposed to move through Cyprus. Beginning months ago, some Russian companies were hedging their bets by moving some of their banking business to Latvia, another significant provider of financial services to the Former Soviet Union. How smooth the transfer will be remains to be seen.

Finally, there will be consequences that are not only unintended, but completely unexpected—the unknown unknowns of the resolution effort. Stay tuned.

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