What the Cypriot ‘solution’ means for the eurozone – ekathimerini 3/4/2013

The Cypriot “solution” is a game changer. I teach my students that the euro is a freely convertible currency and that in the common European market capital is allowed to move freely. However, both of these concepts have ceased to apply in Cyprus, for the present at least.

I told my students that the eurozone has set up the European Stability Mechanism (ESM) for the financial rescue of member states and the recapitalization of their banks. Loans from the ESM are for the time being added to a country’s public debt (solution 1). In June 2012, the eurozone decided that the recapitalization of banks could be financed directly from the ESM (solution 2) after the completion of a single bank supervisory system. However, since October, Germany and other nations have rejected the idea of direct bank recapitalizations from the ESM. They also seem indifferent to the third pillar of banking union, the common deposit guarantee scheme.

Neither of the above solutions was implemented in Cyprus. Solution 2 was a nonstarter: Very few parliaments would accept the ESM financing Cypriot banks flooded with so-called “murky Russian money.” Solution 1 was also ruled out as it would send Cyprus’s debt to 180 percent of GDP. As a result, the EU and the IMF agreed on the “Cyprus solution.” Recapitalization would be financed by a resolution of failed banks and a haircut on creditors (shareholders, bondholders and uninsured depositors).

It’s too early to say if the “Cyprus solution” will be more widely applied in the future. However, it certainly goes against the idea of a European banking union. Banking union is not just a single, centrally controlled supervision and restructuring; it is breaking the cycle between banks and sovereigns. Sure, a Cyprus-style recapitalization of banks does not directly increase public debt but it does increase “country risk.” Failed banks aggravate the repercussions of fiscal problems. Every bank problem becomes a national problem. Weak economies become even weaker while strong economies become stronger. The gap between the “virtuous” North and the “problematic” South grows, as investors on the periphery feel even more insecure. The cost of capital increases even more for the economies of the South. I do not know whether European Central Bank President Mario Draghi can be happy about this development which undermines the ECB’s common monetary policy. But at least the euro is weakening, helping recovery.

To be fair, the Cypriot “solution” is progressive in principle. Tax havens, oversized banks and casino capitalism are finally under pressure. Short-term fiscal transactions are subject to tax. The ECB can close down a bank by refusing to provide cash. Investors should take responsibility for their actions, putting pressure on bank administrators so that the state does not always foot the bill. All that is correct in principle. But a wider application, now that banking systems are hemorraging simply because of the shock of the crisis, entails a great deal of risk. Europe must act before things spin out of control.

The new framework for passing the cost of bank restructuring on to private investors, currently being hammered out by the Commission, will not go into effect before 2018 – unless somebody manages to bring it forward to 2015. But the controversial comments by new Eurogroup President Jeroen Dijsselbloem have created problems for bank recapitalization in the periphery countries. Once again, the eurozone has rushed to draw up new fire regulations to avert the next crisis while the blaze from the previous one has yet to be extinguished.

Direct recapitalization from the ESM would allow European control of Cypriot banks and their restructuring. It would be the best solution. Regrettably, when we needed more Europe, political leaders chose to avoid skeptical parliaments, and the eurozone chose to sacrifice unsuspecting, if not necessarily innocent, depositors and businesses who woke up on March 25 to find out they had lost 40, 80 or 100 percent of their deposits.