Would a Euro Area Banking Union Have Saved Cyprus?

Philip Arestis and Malcolm Sawyer

Whether a euro area banking union would have saved Cyprus from its recent TROIKA (of European Commission, European Central Bank and IMF) tragic treatment is a very interesting question. If it would, then clearly a move towards a banking union, as part of the construction of a political union should be a major component of the reconstruction of the euro area. As we argued in our March 2013 blog, the European Union (EU) summit meeting, 28th/29th June 2012, took a number of decisions in terms of a possible euro area banking union. The most relevant decision was the creation of banking supervision by the European Central Bank (ECB), banking licence for the European Stability Mechanism (ESM), and financial assistance by the ESM to governments, members of the euro area, when in financial difficulty. The banking supervision, however, will not come into full operation before 2014. ESM member states would then be able to apply for an ESM bailout when they are in financial difficulty or their financial sector is a threat to stability and in need of recapitalization. This is exactly the problem with the recent Cyprus problem, as we now elaborate.

Essentially the major problem in Cyprus has been the size and insolvency of its banking sector. It is far too big in relation to the total economy (ten times its annual GDP is often quoted by the TROIKA; being big relative to economy means its assets and liabilities relative to GDP are large); it is also the case that as an off-shore financial and business centre, the Cypriot banking attracted a significant amount of foreign deposits. The first feature poses the danger of a ‘systemic risk’ for the entire economy when one or more banks fail. The second feature exposes Cyprus to accusations, such as those from politicians in Germany and elsewhere that Cyprus has become a ‘money-laundering’ centre within the European Union. By the summer of 2012 it became clear that the two biggest domestic banks in Cyprus were in trouble because of huge losses from the exposure of their branches in Greece, in view of the depressed macroeconomic conditions there, promoted by TROIKA; also in view of the ‘haircut’ of the Greek sovereign debt, of which Cypriot banks had acquired a great deal by 2010. This mixture of wrong decision-making by Cypriot bankers and bad luck created the need for bank re-capitalisations. As a result, Cyprus applied for financial help from its partners in the euro area in the summer of 2012.

The request by Cyprus for a bail-out has certain unique features. The tiny economy of Cyprus requested 17.5 billion euros which, by contrast to the previous Southern European bail-outs, was a comparatively trivial sum in absolute terms. It was, nonetheless, quite large, nearly 100%, when expressed as a percentage of Cyprus GDP. The initial negotiations between the TROIKA and the outgoing government of Cyprus were accompanied by political noises from Germany implying that the German electorate was fed up with having to hand over money to the Southern European periphery yet again. The reason as to why the heavily indebted southern periphery of Europe was morally ‘undeserving’ of financial help was simply undesirable money-laundering. The argument produced is that hard working and prudent German tax payers should not be expected to rescue an overblown banking sector in Cyprus, which became a ‘tax haven’ for wealthy non-Europeans. These are especially Russians, whose deposits in Cyprus are thought to be of the order of 25bn euros, an amount that is almost one-third of the total deposits in the Cyprus banks. The depositors in the Cyprus banking system should be partly expected to rescue their economy, a proposal that was apparently initiated and promoted by the IMF part of TROIKA. The European Commission was reluctant on this score, fearing a bank run in Cyprus and potentially elsewhere in the euro area. Such a plan, it is argued by TROIKA, helps to reduce the unsustainable large banking and financial sectors of Cyprus. It is also the case that to the extent the ‘bail-in’ of the banks in Cyprus is successful it will introduce some market discipline in banking. By sending the message to all depositors in all banks that if a bank needs re-capitalisation they may be asked to bear some of the cost, the depositors will be forced to take more care where they ‘park’ their savings. Unfortunately the world is a much more complicated place to rely for such arguments to be uncontroversial. This is particularly so in the world of money and finance. In any case, and as the editorial of the Financial Times (18 March 2013) rightly commented “instead of throwing Cyprus a life-buoy, leaders put a millstone around its neck”.

When confidence in the banking system weakens then the safety of bank deposits is substantially in peril. This is exactly what happened in Cyprus. A long-term solution would be a move towards a banking union and a single euro area bank deposit guarantee scheme, along with a fully fledged ‘lender-of-last-resort’ function including ability to intervene in the sovereign debt market as well as the secondary markets. Germany has resisted this solution, arguing that it would only contemplate such action only under a full-blown fiscal union. Such a suggestion is pertinent not merely in terms of the introduction of the proposed solution but also for the long-term survival of the euro area. This is desperately and immediately needed, though. We may conclude that both a European Banking Supervision and a European Banking Resolution Authorities are needed but for them to be successful they would have to come under a political integration arrangement, which would provide the necessary fiscal capacity desperately and urgently required at the euro-area level. The Cyprus crisis has vividly demonstrated the need for such a move. The euro-group policymakers should concentrate their efforts on correcting the various serious ‘design faults’ of the monetary union in Europe, especially the absence of a banking union. They must avoid imposing more austerity and misery and creating conditions for bank runs. Clearly such solutions amount to a nail in the coffin of a banking union and a setback to any serious effort to reform the single currency in Europe.

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