Why the Cyprus Bailout Could Set Banking Back 300 Years

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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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Join the conversation. Click here to jump to comments…

  1. Rob Brown | March 19, 2013

    Gold is the answer!!

  2. Christian KIRCHER | March 19, 2013

    this is very clear analyze of the situation in Cyprus and its impact on the world economie. I think its the first step to dark times. Does remember the spoliation of jewish property in germany under the Hitlerdictatorship. This is just a first step ,, so in a few month when they need more money to pay the interest rates of their debts they will start again and make a second tax ? yes probably they will as it worked the first time. And its an easy way to find money. And other countries will follow the example. who is next? spain, italy, portugal or france?
    personally I dont trust any more any government or bank. there are so few reasons now to be able to trust them….

    • DD | March 19, 2013

      Christian – Listen to "Churchill's War" and "The Faking of Adolf Hitler for History" via You Tube. These are old videos now, but is an interesting listen.
      May I also suggest you read "The Creature from Jekyll Island" by G. Edward Griffin.

  3. Charles Harris | March 19, 2013

    This is particularly troublesome considering the present US leadership. They certainly are not to be trusted and undoubtedly are looking at ways to seize American's bank accounts, IRA's,etc.
    The tax scheme was unfortunately brought up by Supreme Court Justice, John Roberts, as a legal way to fund Obamacare.

    • DD | March 19, 2013

      In reality Charles, The US couldn't lead anyone around the block!! And since when was the US a trust-worthy country?

  4. Richard | March 19, 2013

    Is it beyond the realms of possibility that the Cyprus cash grab is a test of the public will by the EU Bureaucrats?

    Using Cyprus as a test bed for public sentiment would seem to make sense. It's a small island with, by European standards, a relatively small population; this makes controlling the flow of people (and wealth) across borders easier than a EU mainland country. Theoretically it would also be easier to "manage" civil unrest within the few cities and towns on Cyprus than say Lisbon or Madrid.

    I can just imagine the governments of the other cash-strapped countries watching Cyprus with interest to see if they could pull off a similar heist, Francois Hollande is probably salivating at the thought of grabbing more cash from the "Rich" to prop up the ailing French economy.

    If the Cypriot public's response to this theft is anything less than robust, I will not be surprised to see this type of government looting spread quickly to other countries.

    Just a thought.

  5. Alberto Esposito | March 19, 2013

    Well I have to say that this is not a precedence, Italy in the early
    90's this type of behavior took place at a rate of 7% of my parents
    account ,if I remember correctly.
    We were struggling at this time trying to create a small business that
    took us around 9 month's of administrative hurdles and the cost
    related to the lease space ; just after we officially open I was
    told that if we closed the activity that we would be paid officially ,
    can you imagine….!!!
    Looks like I haven't seen anything yet…!!!
    Risk management ????

  6. Warren W | March 19, 2013

    Martin,
    I agree completely. Great article. The outrageous levels of leverage the banks currently have is a recipe for disaster. I think people's level of trust in their banks is trending lower, and doubly so for the government. I believe the US Government is eying the 401K's/IRA's of everyone in this country and will somehow figure out a way to force them to purchase USG debt instruments. I know that sounds absurd, and it is, but the politicians are desperate for additional funds and that big pile of money, (upwards of 18T dollars), is just too big a temptation to ignore. Of course if they did take action to invade citizens personal 401K/IRA's it would have disastrous consequences and would likely backfire in the long run. The problem, obviously, is spending and entitlements and until the government can cut programs and drastically reduce spending, (not just the rate of growth), we are doomed to a calamity that will make the Great Depression look like a nice Sunday walk in the park. Demographics alone prove this. Thanks as always for all you do to educate us and keep us informed. Keep up the great work.

  7. SIDNEY H KOSANN | March 19, 2013

    THE TRUTH IS THAT THE U.S. IS BANKRUPT, THE REST OF THE WORLD IS EVEN IN WORSE SHAPE. THAT MAKES GOLD AND SILVER THE ONLY TRUE MONEY.
    PROTECT IT BY HIDING IT FROM THE GOV'T. THEY WILL USE ANY AND ALL MEANS TO TAKE IT AND ALL YOUR OTHER ASSETS AWAY, IN AN EFFORT TO SAVE THEMSELVES AND THE BANKS AND THE FED. FOREWARNED IS FOREARMED.
    GO TO SILVER OVER GOLD, THERE IS NOT ENOUGH TO HELP THE GOV'T OUT OF IT'S (OUR) MESS, AND IT IS HARDER TO FIND. FIGHT GUN CONFISCATION, YOU MUST HAVE A MEANS OF PROTECTING YOURSELF.

    WW2 VETERAN

    • DD | March 19, 2013

      SIDNEY – How can the rest of the world be in even worse shape than the US when in FACT the US is the most indebted country in history? This to me does not add up!

      How can the most indebted country in history have a triple AAA grade when others don't?

      I hope you can see a little of the hypocrisy now!

      • mike jones | March 20, 2013

        Answer is easy really. The US owns and controls the most distructive military weapons in the world along with the technology to deploy them.On top of that the US citizen is allowed weapons on their property.This is a good thing. The rest of the world has had control of its citizens in the vast majority of developed nations a very long time.And the USA is in complete agreement that such control should continue.You don't think that the USA diplomats meet with other countries leaders to trade their women do you?Maybe they do! I don't know. However I would bet they don't.

  8. fallingman | March 19, 2013

    Excellent article.

  9. Former Real Banker | March 19, 2013

    The simple solution to this heinous 9.9 % Tax on Cypriots Bank Deposits, a form of really negative interest – would be to give each depositor so affected Preferred Stock, with full share holders voting rights, say for each equivalent share of US$1.00 valuation of taxation paid by them. This would give depositors some equity in exchange for their taxation. All Taxation is a very bad idea – but sooner or later our own wonderful avaricious U.S. State & Federal tax collectors will want to adopt similar draconian taxation bearing mind that the U.S.A. is now a totally Socialist Country, and getting more so everyday with every political action in Washington DC.

  10. BamaGal | March 19, 2013

    I have a great thought! Why don't we all take our hard earned money out of all the banks.
    Ask Serta to build a pocket into their mattresses and store our money there. To pay our monthly bills we have a prepaid credit card that we can pay expenses. The rest of the money we purchase a new gold money graphene card. Keep your money away from the robber barrons.

    • robert | March 19, 2013

      You are dead right. There is presently no reason for small savers to keep their money in banks. The banks make money on it, while risking it, and pay you nothing in return. The interest we should have been paid over the last several years has been kept by the banks who invested in treasury bonds to collect interest from us taxpayers. You should keep no more money in a bank than required to pay monthly bills. What you do with the rest should be private.

  11. Alejandro F. Merigo R. | March 19, 2013

    Very illustrative and interesting article. A must to read since history does have an impact. Just think all that money can do to help out their own country men but what about the russians who have somehow taken over Cyprus economy.
    They will most likely get the most out of any settlement, by sacrifice and attrition at the expense of others. But what really unsettle me is the fact that the Troika still hasn't thought out of the box, they keep punishing the little guys and rescuing the big ones, the banks I mean, but just look at the havoc this has created worldwide, the uncertainly of the markets and to an extend non performing finance ministries and financial gridlock…! Not to mention sequester mentality.

  12. Curtis Edmark | March 19, 2013

    The scary thing is, is this is merely the tip of the iceberg.

  13. Leslie Belden | March 19, 2013

    Love this article! Another thought: the central banks aren't all that worried about anything they do–because depositors have probably figured out that there's not much point in a run on the bank when the money you're going to take out of the bank and guard with a shotgun isn't worth anything anyway.

  14. Ric | March 19, 2013

    In response to Martin, the government in the uk are already doing this. This have bought in an opt out pension system being introduced next month. The money raised from this is going to buy government bonds / debt no less! By the time the population get it back inflation will have been that high it will be worth not n e way !

  15. Ric | March 19, 2013

    Buy physical gold, gold gold!

  16. Joseph Darrow | March 20, 2013

    Banks should be required to operate as banks – take deposits and pay interest for the use of depositor's money, and, make loans at a somewhat higher interest rate to make profits. This won't happen because the banks support, with big bucks, the best paid congress in the world.

    • Robert in Canada | March 24, 2013

      Some countries actually do force banks to just be old fashioned banks (Canada, Australia, New Zeland, Singapore, Malaysia, and a few others).

      Those countries have solid economies and not having the problems the US and Europe have.

  17. Bob | March 24, 2013

    Totally agree with the leveraging concern. But the don't lose sight of the fact that by the Fed's efforts to increase inflation and by holding interest rates near zero, US savers are already being "taxed" to recapitalize the banks, and this "tax" applies to ALL deposits, insured or not. Cyprus' approach is at least more "honest".

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