THE EUROGROUP OF Euro zone finance ministers met in Dublin last week. Irish and Portuguese efforts focused on securing maturity extensions to their respective bail out loans. However, the Cyprus debacle shows they would be wise not to let momentum towards banking union slip. Europe’s careless and incoherent handling of the Cypriot bailout, and the controversial decisions to impose losses on depositors and enforce capital controls, will have traumatic and long-lasting political and economic consequences for the Cypriot economy.
The write-down in 2012 of Greek sovereign bonds in 2012 made the Cyprus bail-out inevitable. The Cypriot banks held a very large amount of Greek bonds and had effectively become insolvent as a result of the write-down. The imposition of losses on depositors and the enforcement of capital controls broke new ground in the euro crisis. Due to the depositor bail-in many individuals, businesses, and institutions in Cyprus lost over half the value of their bank accounts overnight. One knock-on effect is that many workers went unpaid last month. Cyprus now faces a deep and prolonged recession with double digit declines in GDP and increasing poverty.
Deposit-taking banks are vulnerable to bank runs because their liabilities (e.g. deposits) are on average more liquid than their assets (e.g. mortgage loans). Merely the perception of insolvency can trigger a bank run. Capital controls were the chosen solution to prevent outright bank runs in Cyprus. Capital controls essentially suspend the ability of depositors to withdraw deposits and can have a destructive effect on the domestic economy. Deposit guarantees can be a superior alternative, but a sovereign deposit guarantee is only as good as the creditworthiness of the sovereign.
Ideally, the European Stability Mechanism (ESM) would have been deployed to recapitalise the Cypriot banks. Unfortunately the grand promises made in June last year to break the pernicious link between banks and sovereigns proved false. The link between banks and sovereigns is as tight and as dangerous as ever. The lesson seems clear. Each country must look after itself.
Slovenia – with its undercapitalised state-owned banks – is next in line to be consumed by the crisis. Europe’s treatment of Slovenia will tell us whether the Cypriot ‘template’ will become the norm. If this template were indeed to become the norm then a deterioration of the situation in Spain could bring the euro crisis to its most dangerous point. What should be done?
The goals are to break the link between sovereigns and banks, to protect taxpayers and depositors, and to halt capital flight from the periphery. If depositors continue to perceive banks in the periphery as inherently riskier than banks in the core then periphery banks will suffer from a lingering competitive disadvantage and vulnerability. The minimum needed to achieve these goals is a deposit insurance scheme centralised at the Euro zone level.
The Federal Deposit Insurance Corporation (FDIC) model of deposit insurance was introduced in the United States by Roosevelt during the Great Depression as a response to endemic bank runs and provides a good template for the Euro zone. Simply put, centralised deposit insurance is a necessary component of any monetary union characterised by massive transnational banks that can dwarf their home countries in size.
Centralised deposit insurance would have to be accompanied by centralised banking union. Banking union means centralised supervision and regulation at the Euro zone level including an independent authority with the power to close down insolvent banks. Banking union is a necessary quid pro quo for pan Euro zone underwriting of bank deposits and is desirable in any case. All Euro zone financial institutions should automatically be covered.
Taxpayers would be protected by giving the independent authority the power to unilaterally resolve (i.e. shut down) insolvent banks and other financial institutions. There should be no liquidity support for insolvent credit institutions, and banks should be closed and allowed to fail where shown to be insolvent by mandatory regular stress tests conducted by the independent authority.
If the euro crisis continues to be mismanaged then the social, economic and political consequences could be long lasting for countries like Cyprus, Slovenia, Spain and Ireland, and the future of the euro itself will remain under threat. It is time to recognise the design flaws in EMU. The failure to supplement monetary union with a banking union was a key policy failure that needs to be addressed immediately. Time is running short.
Tom McDonnell is a policy analyst with TASC. He has also lectured in Economics at NUI Galway between 2005 and 2010.
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