The Cyprus rescue package under discussion, with its tax on bank deposits, has raised strong emotions and triggered fiery and controversial reactions. Some economists and commentators warn that it might spark bank runs in the larger Southern European countries and ultimately result in the disintegration of the Eurozone. Wyplosz (2013) has eloquently made these points in his recent Vox column.
At the time of writing, Cyprus’s Parliament has rejected the terms of the rescue package, with not a single vote in favour (36 “no” and 19 abstentions). This has further raised the stakes and heightened uncertainty.
With this caveat in mind, the key questions are:
- How dangerous is this rescue package?
- What are the alternatives?
In addressing these, we need to distinguish three issues.
- Overall cost of the sovereign rescue and its distribution
- Financial stability
Let us start with fairness.
The originally proposed deposit tax leaves much to be desired. A 6.75% tax on small depositors, compared to 9.9% for large depositors, is blatantly unfair. The EU and IMF have argued that small depositors should be protected by upholding the EU-wide deposit guarantee, which should safeguard deposits up to 100,000 euros, and the Eurogroup has reiterated this position in a recent statement (Eurogroup 2013). The Cypriot authorities have so far decided otherwise.
To safeguard small depositors, Cypriot authorities would need to impose a higher levy on larger deposits because they face a budget constraint driven by the overall cost of the sovereign rescue, which is the second issue. Cyprus’ banking system has grown disproportionate to the size of the economy: its total assets are over seven times GDP; deposits are about four times GDP, and 37% of these are by non-residents, mostly from outside the Eurozone. The banking system faces an estimated recapitalisation need of 10-12 billion euros, equivalent to about 60% of GDP.
- With public debt already close to 90% of GDP, the government cannot afford to bail out the banks.
The public debt ratio would jump to about 150% of GDP, which would inevitably imply a sovereign debt restructuring down the line.
Who should bear the cost?
Outright debt forgiveness would be politically infeasible. It would run into strong opposition in Germany and other creditor countries, as well as in countries already suffering austerity to either comply with or avoid an EU/IMF-led programme. So Cyprus must bear part of the cost, and has been asked to raise 5.8 billion euros to add to the 10 billion of international financing. Ireland, at the beginning of the financial crisis, extended a broad guarantee to its banking system exactly because of contagion fears. It has since been harshly criticised for taking that step, which translated into a larger public debt stock and therefore a heavier austerity burden on the general population. If Cyprus did not extract a pound of flesh from the banking system, the Cypriot population would pay to indemnify the same foreign depositors who have been instrumental to causing the crisis.
- If the banking system has to pay a price, the hit has to be on deposits.
The value of junior bonds and senior unsecured bonds is just too small.
- Taxing all deposits is an extremely ill-advised decision. The deposit guarantee should be honoured, which could be done by levying a higher tax on large deposits.
Cypriot authorities, however, appear reluctant to do so.
Reneging on the deposit guarantee undermines progress towards a banking union. The guarantee is coordinated across the EU, but it remains the responsibility of national governments; this is inevitable as long as fiscal union does not progress at least to the stage of providing common financing for deposit insurance. Ideally, both banking and fiscal union would be sufficiently advanced to make it impossible for a national government to renege on a deposit guarantee. But they haven’t, and that decision therefore still rests with the Cypriot authorities.
This leads to the third issue, financial stability.
Financial stability issues
Government-backed deposit insurance has long been recognised as a fundamental tool to prevent bank runs and ensure stability, as in the seminal work by Diamond and Dybvig (1983). Several studies, on the other hand, have pointed out that deposit insurance is also a source of moral hazard: banks have an incentive to pursue higher risk (and higher return) investments as deposit insurance weakens the link between portfolio risk and ability to attract deposit—see for example Demirgüç-Kunt and Detragiache (2000), who find that deposit insurance increases the likelihood of banking crises (see also Demirgüç-Kunt, Kane and Laeven 2008). These findings lend support to the idea of taxing deposits above the deposit insurance threshold. But can this trigger contagion?
The deposit tax on the table in Cyprus is essentially a wealth tax. This is an efficient way to reduce the burden of debt, as long as a convincing case can be made that the move will not be repeated—which is a high hurdle, as discussed for example by Eichengreen (1989). And in this case, the most important question is whether Spanish and Italian depositors can be reassured that the move will not be repeated in their own countries. I think the answer is yes, for several reasons:
- First, the argument that ‘Cyprus is different’ is quite persuasive.
Cyprus is a small country with an outsized banking system created via lax regulation.
- Second, the deposit tax is an efficient way of “bailing in” foreign creditors, given the high share of non-resident deposits.
- Third, and perhaps most importantly, I believe Italian and Spanish savers are already aware that they are subject to their own sovereign risk: when a country falls under severe budgetary stress, income and savings are at risk as governments try to shore up public finances.
This is not new. In Italy, the Monti government has already raised or introduced taxes both on income and wealth (house taxes). Italians will also still remember the precedent of an extraordinary tax on bank deposits in 1992, though of a much smaller magnitude (0.6%). (Incidentally, it is worth noting that zero interest rate policy is also effectively a tax on bank deposits.)
- Finally, the ECB has been crystal clear in its commitment to avoid systemic instability in the Eurozone, and could step in to calm any signs of excessive anxiety in other Eurozone members.
The rejection of the deposit tax by the Cypriot parliament opens another tense chapter. The ECB has indicated that without a bailout, some Cypriot banks would become insolvent, and hence ineligible for Emergency Liquidity Assistance. The implicit threat point is that Cyprus might be forced to leave the Eurozone. This raises the stakes in the poker game.
- The first consideration is that Cyprus got into trouble largely because of its own mistakes, not as a consequence of a natural disaster or other adverse shock. It should therefore contribute to its own rescue effort.
Options are limited, and as discussed above a tax on deposits seems a logical part of its effort. Ideally, deposits under 100,000 euros would be spared both for fairness and to respect the deposit insurance commitment. A tax rate of 15% on deposits over 100,000 euros would be enough to raise the targeted revenue—but that decision rests with the Cypriot authorities.
At this stage in the poker game, international lenders are unlikely to fold—and indeed they should not. Warnings that the Eurozone might disintegrate are unnerving, but they have been heard before, and the Eurozone is still in one piece. Every time the financial doom-sayers cry wolf, they lose credibility (and unfortunately increase the risk that it will all end in tears).
- Cyprus is different, and a tax on bank deposits there is very unlikely to trigger bank runs in other Eurozone members—especially with the ECB standing behind solvent banks.
- The tough treatment of Cyprus will remind other countries that there is no “free lunch” alternative to fiscal and structural adjustment.
- Finally, this episode should lead EU policymakers to accelerate institutional reforms on banking and fiscal union, to reduce the systemic risk in the Eurozone’s banking sector.
As Martin Wolf (2013) has noted in a recent piece, the banking sector should not still be an existential threat to the single currency.
Demirgüç-Kunt, Asli and Enrica Detragiache (2000), Does deposit insurance increase banking system instability? An investigation, World Bank
Demirgüç-Kunt, A.; Kane, E.; and Laeven, L (2008), Deposit Insurance around the World: Issues of Design and Implementation, Cambridge, Mass.: MIT Press.
Diamond, Douglas and Philip Dybvig (1993), “Bank runs, deposit insurance and liquidity”, Journal of Political Economy.
Eichengreen, Barry (1989) “The capital levy in theory and practice”, NBER working paper 3096
Eurogroup (2013) "Statement by the Eurogroup President on Cyprus", 18 March 2013
Wolf, Martin (2013) "Big trouble from little Cyprus", Financial Times, 20 March 2013
Wyplosz, Charles (2013), "Cyprus: the next blunder", VoxEU.org, 18 March 2013