March 17, 2013

What's wrong with the Cyprus bailout

The financial blogosphere is ablaze with talk of a bailout in Cyprus. The short story is that Cyprus has been forced by Germany to rob deposit holders of 6.7% - 9.9% of their bank balance, in the form of a so-called 'upfront one-off stability levy'. Not unsurprisingly people are screaming theft, bloody theft.

After some thought I have to say I agree, but with slightly more nuance: There's nothing immoral about imposing losses on deposit holders. Banks fail. People lose money. That in itself doesn't make it theft. Money is not unconditionally safe just because it's on deposit with a major financial institution.

But when loses are imposed in a way that benefit some at the expense of others, then we are approaching that moral boundary. Bankruptcy law typically says that loses are to be imposed in a certain order:
  1. First shareholders are wiped out,
  2. then junior bondholders,
  3. and only then senior bondholders and (uninsured) deposit holders.
In societies as far back as Rome it has been considered a crime to circumvent this order, to benefit junior creditors at the expense of senior.

But in modern day Europe there's also deposit insurance. This is usually a guarantee that deposit holders will receive their first 100 000 € back from the government, if their bank should fail. The government of course has other liabilities, like government bonds, but in my opinion it can at least be argued that deposit insurance should be seen as senior to bonds.

This gives us an idea of the order in which a "morally just" bailout would impose losses in a situation where both the banking system and the government are insolvent:
  1. First bank shareholders should be wiped out(!),
  2. then junior bank bondholders,
  3. then senior bank bondholders and uninsured depositors,
  4. then government bond holders,
  5. and finally, only if the above doesn't cover it, insured deposit holders will have to take a haircut.
We seem to be pretty far from this in the case of Cyprus: Shareholders will likely be diluted (because deposit holders will receive some "compensation" in the form of bank shares) but not wiped out. Junior bondholders on the other hand may be. Uninsured depositors will receive 90 cents on the Euro while senior bondholders will likely be made whole(!), and so will government bondholders. But insured depositors will take a 6.7% hit.

Many say this is still the best option. If loses are imposed on senior debtors or government bondholders there will be "contagion", and if shareholders lose faith the banking sector could implode. Safer then to take a little from the many, hopefully diluting the sense of loss enough to get away with it.

But a crime isn't suddenly okay just because you have a good reason. As painful as the failure of a major financial institution may be I don't think it compares to the pain we all have in front of us if we abandon the rule of law. So, in my book the proposed Cyprus bailout is theft. Yes, even if you call it a tax.

Fiat justitia ruat caelum, "let justice be done though the heavens may fall." That's my 2 cents at least.

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