Perhaps being rational is not a goal of the European Central Bank or the International Monetary Fund, but it seems providing Cyprus with an ultimatum to generate their share of a bailout for their financial sector within four days’ time would not be the optimal strategy. These were the same officials, however, that thought it was a good idea to instigate the panic that created the possibility of a bank run. Thank goodness Cyprus enforced a bank holiday for the last week, because if it was not the lack of liquidity that would of caused their banks to fail, the policy makers would have accomplished this in the form of a bank run through their initiatives.
As of last Sunday, not since the lessons learned from the Great Depression and the utilization of a scheme known as deposit insurance has the idea of a bank run ever even been so credible. Quite simply, a banking crisis stems from the issues of solvency and liquidity. When a bank does not have sufficient assets to cover their liabilities, they run into the issue of solvency. When they have trouble borrowing to satisfy their short term liabilities, there is the issue of liquidity. As of late, the ECB has been providing Cypriot banks with Emergency Lending Assistance (ELA) in order to ensure the liquidity of their financial institutions, and they threaten to halt this lending next Monday. It is important to decipher though between solvency and liquidity, as central banks only aim to assist in the latter. It is not their intended mission to float insolvent banks, but they are walking a fine line with Cyprus.
And it’s their troubled banks that last summer put Cyprus in a similar situation to Greece, Ireland, Spain, and Portugal. The lack of liquidity in their financial system required the Cypriot’s to request a bailout. There is a stark difference between the little European Nation that contributes a mere 0.2% of total Eurozone output to prior rescued nations, and that is with regards to whom their debtors are.
The fact that the majority of the large depositors are Russians and not predominantly other Eurozone nations somewhat alleviates the fear of contagion. Not to come across as overly simplistic, but the escalation of the Euro crises a few years prior was due to the fact that member nations held one another’s debt. Once the first domino fell, contagion quickly spread. That same fear is not as apparent with the situation in Cyprus.
Maybe Cyprus could very well be the first nation to leave the Euro currency, but unlike the rash deadline imposed by the IMF and ECB, this event will not unfold quickly. The total public and private external debt, meaning from lenders outside of Cyprus is approximately five times the country’s GDP. And half of that debt is short term deposits, hence why this situation is serious, yet will not unfold quickly. Banks may reopen as early as next week, but that is unlikely. What is likely is accounts will be frozen; depositors will have limited access to their money. If they did have access, they would withdraw their funds only to exacerbate the problem.
The question with Cyprus is no longer if and when they default, but how they default. This is nothing short of a very unfortunate situation for the citizens of this tiny Mediterranean country; however, if there is not some willingness of collective compromise no one gets their money back. Rest assured, there will be compromise because it will be forced. Two initiatives will have to remain in place. One we heard yesterday; the Cypriot Central Bank guaranteed deposit insurance would remain intact on accounts less than €100,000. This will hopefully provide the foundation to prevent a bank panic. The second is that some sort of haircut is taken on deposits or other form of sacrifice takes place. For example it might be in the form a deposit being converted into a long term bond.
There can be rallies in the street and turmoil surrounding government buildings, but plain and simple, when the numbers don’t add up the options are extremely limited.