The March 25th Eurozone deal on Cyprus offers a EUR 12.5 billion bail-out of Cyprus: EUR 7.5 billion in loan refinance for the government of Cyprus; the remainder for the recapitalisation of the Cyprus banking system. Yet the political mishandling of the negotiations by the Eurozone and its deliberate attempt to destroy the international reputation of an EU Member State expose the deep incompetence and deleterious nationalism still at work in Europe. It casts grave doubts over the ability of the Eurozone to manage its far more serious economic challanges. And it sows the seeds of the next financial crisis in Cyprus.
In popular jargon, Cyprus Popular Bank (CPB) / Laiki is a zombie bank. Heavily exposed to non-performing loans in Cyprus and Greece, and hit by the write-down on Greek government bonds, CPB has been operating at loss for two years now.
Yet for 2 years, CPB has been kept afloat by the European Central Bank’s Emergency Liquidity Assistance (ELA) scheme. According to press reports, the ECB has pumped EUR 9 billion into Laiki; according to government contacts, the true figure is higher, up to EUR 11 bln.
The ELA provided to CPB and Bank of Cyprus (BOC) has been weighing heavily on the mind of the ECB’s President, leading to his threat to cut off ELA as of this Monday, 25 March, to Cyprus. More than anything else, this has shaped the “resolution” of the present crisis.
At this point, there are two issues that have to be discussed:
1. EBA / ECB Stress Tests
In 2011, the ECB and the European Banking Authority (EBA) carried out stress tests on the banking sector. Widely criticised at the time as being unrealistic, the results for Cyprus are illuminating. In October 2012, Bank of Cyprus assessed its Core Tier 1 capital requirement increase at EUR 730 million. CPB/Laiki announced that it “passed” the stress test in 2011. The Central Bank of Cyprus gave its approval on both assessments.
Yet subsequent to these rosy assessments, the credit situation of both banks deteriorated rapidly. The first Greek PSI took place in February 2012, leading to the write-down of EUR 206 billion in Greek Government Bonds, and creating losses for BOC and CPB. In the third quarter of 2011, Laiki had a nominal value EUR 3.1 bln of GGB on its books, while BOC had EUR 2.1 bln. 76% of this value was written off, leading to the highest corporate losses in the history of Cyprus. This was compounded by PSI 2, which wrote off most of the remainder of GGB value, in December 2012.
It becomes clear that the ECB/EBA assessments underpinning the stress tests were by that time thrown out the window, as were bank assessments on NPL risk. It is also clear that the decision to write down Greek government bonds, which was a European decision, have led to the insolvencies of CPB and BOC.
2. CPB Nationalisation
In May 2012, CPB was nationalised after suffering record losses due to PSI 1. The government, by that time faced with a massive deficit caused by the 2011 Mari explosion; a deteriorating economic environment in tourism, shipping and property; an unrestrained government spending.
By nationalising CPB, the Cyprus government nationalised not only its loan book, but also it’s ECB ELA obligations, which began in June 2012. Under ELA, emergency liquidity is given to Cypriot banks with the ECB’s approval, but by the Central Bank of Cyprus.
We do not know exactly how much ELA is granted to either bank: neither the ECB nor the Bank of Cyprus releases this information. Ostensibly this is done to protect confidence in the banking system. To an investor or depositor, however, this is an extremely negative event, as it makes an assessment of true risk levels difficult.
Since Cyprus is in the Eurozone, it no longer directly controls its Central Bank system. Unlike the US or the UK, for instance, it cannot implement “quantitative easing” – expanding central bank balance sheet and using the proceeds to buy government bonds or other assets (e.g. mortgage-backed securities). As a result, a relatively simple emergency bank funding line was mired in secrecy and ultimately to a lack of accountability.
In the vote of the Cypriot parliament, one Member stood up and said it was impossible for him to vote for the Laiki nationalisation. The government had not released the true figures, and had not made a proper accounting of risks and liabilities. That MP has since been punished by his political party, consigned to “Siberia”. I am proud to call that MP my friend: his remarks at the time have proved prescient.
Assessment of the Current Bail-out Package
Based on information released to press today, we understand that:
- Cyprus Popular Bank is being liquidated. Deposits under EUR 100,000 will be transferred to Bank of Cyprus.
- Deposits above EUR 100,000 in both banks are being frozen. The CPB deposits will be used in the liquidation; the BOC deposits will be used in an equity recapitalisation of BOC. Depositors are expected to lose 40% of the value of their deposits, but receive BOC share instead.
- The Eurozone will approve the EUR 10 bln bail-out, of which EUR 7.5 billion (approximately) will be used to refinance and support government operations under separate loan conditionality, while EUR 2.5 billion will be used for banking operations.
- Crucially, the ECB ELA credit line to CPB passes to Bank of Cyprus.
What does this mean for Cyprus?
On the face of it, this package is an improvement over the previous package in classical economic terms. It means that rather than punishing all depositors in Cyprus (at all banks in Cyprus), it restricts the damage to larger depositors at the two problem banks. By making these depositors liable for the specific problems in these banks, it removes an element of systemic risk and places renewed investor and regulator attention where it should be.
The liquidation of CPB is a difficult decision, but a correct one. CPB has been a zombie bank for 2 years now, and has been avoiding a real restructuring—in no small part due to political issues. Several political parties have wanted to avoid the political cost of restructuring: this will now be settled with liquidation.
BOC will almost certainly have to pass capital controls to avoid deposit flight. It is uncertain whether capital controls will be extended to the rest of the island’s banks, but in my opinion this is a certainty.
The EU has reaped incalculable damage from the way it has handled this crisis, and caused incalculable damage to Cyprus. EU politicians have gone out of their way to criminalise and stigmatise both Russian businesses and “the Cyprus business model”, calling it a haven for money laundering and other illicit activities. In fact, no proof of money laundering has ever been provided; as stated in other posts, the Cypriot tax system is legal and not the only “onshore” low-tax jurisdiction in Europe. Malta, The Netherlands and other countries have a far lower tax limit on certain types of transactions, while Russian holdings in other EU countries are far larger.
Deposit flight and a switch to other jurisdictions away from Cyprus by British, Russian and other investors are now a certainty.
Rather than solving the ostensible problem of money laundering, the German political hysteria on this issue has simply caused it to metastasize to other countries. We note that there is no regulatory trend in Germany or elsewhere to crack down on transfer pricing in The Netherlands, to require Malta to change its corporate income tax regulations, to regulate Luxembourg’s banking sector (several times the size of the Cypriot one as a percentage of GDP), etc.
As a result, and taking into account the impact of the structural adjustment programme in the public sector, as well as renewed damage to credit availability in tourism and property, and a range of other factors, we believe that the Cyprus GDP will begin a painful process of contraction. In 2013, we believe this will reach a 5% GDP decline, and unemployment of 16-18%. The process will continue into 2014 and 2015.
Moreover, the roots of this “bail-out” are now directly causing the next crisis in Cyprus, which will be the need for a second bank recapitalisation, or possibly a liquidation of the Bank of Cyprus. The BOC’s core problems remain non-performing loans (NPL), poor trading conditions, and the GGB write-down. None of these have anything to do with Russian money laundering or the other nefarious activities attributed to Cyprus by the French and German finance ministers. However, by forcing deposit flight from BOC (and deposit confiscation), the loan-to-deposit ratio will very quickly worsen.
By very quickly, I mean within 2 months, or whenever restrictions on deposit withdrawal ease. This will lead to a requirement for yet another capital increase. An alternative will be to transfer the NPL portfolio to a government-backed “bad bank”, which bears its own peculiar set of risks in Cyprus.
It is not certain to what extent the deposit confiscation will lead to a permanent loss of business for Cyprus. There are numerous advantages to the Cypriot tax regime, particularly for non-EU investors, which have not been touched by the bail-out, and which, ironically, contribute to money laundering: the use of nominee shareholders is an important one. Companies can continue to use Cyprus as a jurisdiction, using three simple methods of managing risk:
a. Remove deposits from Bank of Cyprus into the bank branches of more solid international banks. Cyprus has a range of banks operating, including Societe General, Russian Commercial Bank, Barclays, and others.
b. Continue a company in Cyprus, but hold the bank account of this company outside Cyprus. Cypriot companies can hold bank accounts anywhere in the EU, and anywhere outside the EU. This separates the corporate capital flow from the national risk.
c. Use a “cash sweep” to transfer any funds accruing in Cyprus to other companies, or bank accounts in other jurisdictions, on a daily or weekly basis. This practise has already been implemented in Greece successfully.
The Eurozone has proven to be an emperor without clothes. The political hostility by Germany, France and others; the lack of basic understanding of financial operations and banking confidence; the very real effort to demonise Cyprus and Russia; the stubborn insistence on seizing deposits; the deliberate threats of Eurozone exit: these are not behaviours which will soon be forgotten.
Moreover, they are behaviours which appear ingrained, and which have been fully transmitted to national populations via what can only be described as a yellow press.
It is impossible to see how the Eurozone will deal with its deep-rooted competitive distortions given these political reactions. Rather than addressing an issue calmly and rationally, they stir up the worse nationalistic instincts of a European population already beset by economic crisis. Their “solutions” contain the roots of the next crisis. If the Eurozone is unable to solve a EUR 17.5 billion refinancing scheme, how will it solve the EUR 2 trillion national debt of Italy?
Ironically, this bail-out does absolutely nothing to solve the many “problems” attributed to Cyprus by the Eurozone. In the list below, I present the many reasons German politicians found to vilify Cyprus over the past week, and the impact of the current bail-out:
Cyprus is a Money-Laundering Centre
- There have been no regulatory measures passed on “know your customer” requirements or corporate audits.
- There have been no measures passed on Cypriot banks to verify the sources of funds.
- There have been no changes to the nominee shareholder system in Cyprus, which permits the concealing of beneficial company owners.
Cyprus is a Tax Haven
- There has been no change to the Cyprus tax rate, which remains at 10% for non-resident companies and approximately 16.5% for residents.
- Cyprus retains its system of double tax treaties, including the vital double tax treaty with Russia.
- The other advantages of Cypriot law—light touch regulation, an English language business system, remain.
The Cyprus Banking Sector is Too Big
- The forcible shrinking of the banking sector, by liquidating CPB and causing deposit flight, will create the next round of instability in Cyprus. Ironically, it will also shrink GDP. The final ratio of the banking sector assets as a share of GDP may not change at all.
- There have been no changes to the regulatory authority or staffing of the Central Bank of Cyprus, which has directly and indirectly been exposed to political interference, and has contributed to the crisis by concealing the true financial picture of the Cypriot banking system.
- There have been no changes to the secrecy of ECB ELA and LTRO operations, which distort the market. There have been no changes in the apparently arbitrary way in the which the ECB makes decisions.
The Cyprus Business Model must Change
- By attempting to destroy the offshore business sector, German politicians may have convinced themselves that they have “changed the business model”. If anything, I believe they have increased the likelihood that after a few years, international investors will still be using Cyprus, but moving their money to even less savoury locations.
- There has been no replacement business model. By destroying the international reputation and access to credit, German politicians are doing nothing to help non-performing loans, Cyprus property, Cyprus tourism or any other sector of the economy.
The entire spectacle of European—and particularly German—decision-making in the case of Cyprus is characterised by incompetence, hypocrisy, hysteria, and the loutish behaviour of a schoolyard bully. Rather than solving any issues in Cyprus, it has undermined the trust of international investors in Europe itself, and established the conditions for the next financial crisis in Cyprus, which will almost certainly relate to BOC recapitalisation in the face of deposit flight.
In Cyprus as in Greece, the European leaders have done everything possible through their statements and decisions to destroy international trust in a European Member State. And as with the example of Greece, it appears that these same European leaders have learned nothing.
We look forward to the next European crisis.
© Philip Ammerman