Even by the standards of the EU bureaucracy, raiding the private deposits of Cyprus' banks is spectacularly foolish.
For a measly $5.8 billion euros, the EU has now put the entire Eurozone on edge-not to mention the entire global economy.
It revolves around something as simple as trust. And as a former banker, I can tell you that there's no substitute for the belief that your deposits are safe and sound.
It's a thin line and once it's been crossed it's nearly impossible to repair.
Now savers in Spain, Italy and elsewhere in the Eurozone are left to wonder about the safety of their own accounts.
Here's why savers everywhere should be concerned…
The Problem With the Cyprus "Bailout"
Like Ireland and Iceland, Cyprus has a banking sector that's not only shaky but is far bigger than its overall economy, with deposits of around $90 billion, or five times its GDP.
Unlike most banking systems, more than half of those deposits are in large chunks of over 100,000 euros ($128,000), the limit of Cyprus' deposit insurance. Indeed, about $20 billion of Cyprus' deposits are held by the Russian mafia.
Since Cyprus' president Nicos Anastasiades didn't want to shut down the island's attraction as a money haven and playground for the Russian jet-set, he agreed to a deposit tax of 6.7% on deposits up to 100,000 euros and 9.9% on deposits above 100,000 euros, to satisfy the EU's demand of 5.8 billion euros ($7.2 billion) part of the bank bailout.
But like most schemes designed by politicians and EU bureaucrats, this one has huge flaws, including the fact it angered Russian president Vladimir Putin. Even at this level, with much of the money coming from Cyprus' modestly well-off citizens, Putin described it as "unfair, unprofessional and dangerous."
But the main flaw isn't about Putin. It has to do with the idea of deposit insurance itself.
Under a separate scheme introduced by the EU after the 2008 financial crash, deposits under 100,000 euros are insured by the Cyprus government.
Of course, the "tax" on deposits is a supposedly clever way to get around this without the Cyprus government itself defaulting. However, all this little trick does is call into question deposit insurance throughout the EU and, indeed, worldwide.
That's why this tiny country, with a population of only 800,000 and $17 billion in GDP, has roiled the world markets– it attacked the central principle of deposit insurance.
After all, if governments can just seize deposits by means of a "tax" then deposit insurance is worth absolutely zippo.
Meanwhile in Cyprus, there were a number of alternatives to breaking this underlying bond of trust. The banks have some bond debts outstanding, which certainly should have been written down before the deposits were attacked. In fact, the tax is an attempt to avoid this, and should be resisted on that ground alone.
Instead, because the large deposits are so big, you could raise the required 5.8 million euros simply by a 15% tax on large deposits – but that would make Putin REALLY angry (he personally may or may not have money in Cyprus, but lots of his friends do).
They could also write down Cypriot government bonds, but because the banking system is relatively so huge the write-off would have to be a big one. To get 5.8 billion euros it would take more than a 50% write-down.
In the big picture, Cyprus doesn't matter much, unless EU incompetence and the recalcitrance of its own politicians makes it leave the euro altogether, in which case that currency unit yet again faces the prospect of break-up.
Who Can You Trust?
But in this case, the effect on global deposit insurance systems is much more important.
Deposit insurance was first invented in the United States during the Great Depression as a means to reassure savers about the solvency of banks, a third of which had just gone belly-up. It worked beautifully. Americans trusted the federal government (at least, they did back then), so once deposit insurance was in place savers came to have complete trust in the banking system.
Unfortunately, that same trust had a very bad effect on the banking system itself.
From leverage ratios of $4-5 of assets to $1 of capital in the 1920s, banks leveraged themselves ad infinitum, having leverage ratios of $10-12 of debt to $1 of capital in the 1970s, and up to $30 of assets to $1 of capital in 2008.
Even today, after de-leveraging, J.P. Morgan Chase (NYSE: JPM), in many ways the most solid of the big banks, had assets of $2,359 billion at the end of 2012 and tangible equity of only $146 billion — or a ratio of 16.2 to 1. As recently as 2010, JPM's leverage was 19.3 to 1.
At those levels you can see the dangers that kind of leverage presents.
In fact, I counseled the National Bank of Croatia to this effect, when they were designing their deposit insurance system in 1996-97, advising them to have insurance covering only 90% of deposits. Unfortunately the politicians in the Croatian parliament overruled us, so Croatia now has the same damaging 100% insurance as everywhere else.
So the depositor today ends up with the worst of both worlds. He can't rely on the banks not to go bust, given their current absurd levels of leverage (which are of course encouraged by Ben Bernanke's money printing). On the other hand, now there's a question of whether he can rely on deposit insurance either.
If these worries become really serious, it will be devastating for the world economy. Small savers will take their money out of banks and resort to household safes and a shotgun.
If savers no longer have a solid place in which to put their money, we will have undone the financial revolution of the last 300 years, and returned to a world in which Samuel Pepys didn't trust the local goldsmith, so buried most of his wealth in the back garden. Needless to say, that won't do much for small business – the entire flow of finance will seize up altogether.
The solution is to do away with deposit insurance, forcing banks that want to attract depositors to hold $1 of capital for every $4-5 of assets, at most.
Eliminating Ben Bernanke and going back to a gold standard will probably be necessary too-even though that's not likely to happen anytime soon.
But if politicians continue behaving as badly as those who designed the Cyprus bailout, the gold standard will be the only economically viable alternative.
With this "bailout" all the EU has done is open up a Pandora's Box.
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