Cyprus Bailout Ups Bank Run Risk

By Willem Verhagen, Chief Economist at ING Investment Management

The main problem of Cyprus is of course its oversized and undercapitalised banking system. As we know all too well by now this poses a threat to sovereign solvency as well. This should be distinguished from the other peripherals such as Spain and Italy, where the main problem is that a liquidity drought can lead to a self-fulfilling solvency crisis via exponentially rising borrowing costs.

In cases where there is such an obvious sovency issue, the Troika invariably opts for a form of private-sector bail-in as part of the solution. In the case of Greece this took the form of a haircut on sovereign debt. For Cyprus, sovereign solvency is only under indirect threat, so last night it was decided to spare sovereign creditors and go to the root cause of the problem. As a result, bank creditors, including large (above €100K) deposit holders are being bailed-in, although only for those banks that are truly insolvent.

This takes the immediate threat to the stabililty of the eurozone away, but it is unlikely to be the end of the story. The fact that depositors below €100K were protected is certainly a positive and should give some reassurance to small deposit holders in other EMU countries. From a long-term perspective, the fact that creditor bail-in is the first port of call rather than a bail-out by taxpayers will improve the stability of the financial system as diminishes moral hazard issues and gives lenders more incentives to exercise due diligence.

Nevertheless, in the short run this may create some additional complications for a region that is still in crisis fighting mode and also deals with a protracted recession. One can expect a structural increase in the risk premium on (peripheral) bank funding costs, which could have negative repercussions for credit supply and private sector borrowing costs. Also, the prospect of private sector bail-in may cause large depositors to move away from other nations with oversized banking sectors. The risk of bank runs has thus increased somewhat. All in all, one can say that the degree of fragmentation in the euro area has increased again over the past two weeks even though it remains difficult to say by how much. This thus diminishes the postive effects from the OMT somewhat and may delay the EMU recovery.

Besides all this, we expect Cyprus to need more funds than the €10bn currently on the table in future. Of course, we have been here before in the case of Greece as well. The banking sector was a very important pillar for the Cypriot economy. Severe downsizing thus means a very severe recession as the country needs to make the transition to another growth model. Budget deficits will thus overshoot their targets in the next few years and the contraction in GDP will put upward pressure on the debt to GDP ratio. By 2020 the latter may thus well be a lot higher than the 100% forecast by the IMF.

Finally, the events of the past week have made clear that the core countries and the ECB are now more willing than in the past to draw a clear lind in the sand. For instance, the central bank publicly threatened to withdraw funding for Cypriotic banks if a solution was not found before Monday. The willingness to make clearer threats and lend crediblity to them by restricting their own degrees of freedom to act in future should make the negotiation position of the core countries stronger in future.