The final deal agreed to restructure the Bank of Cyprus involves the bail-in of senior bond holders and large depositors (over 100,000 Euros). What this means is that in return for the seizure of some of their money, bond holders and depositors will be provided with shares in the resolved banks. They will become part-owners of the bank.
From the point of view of small depositors, this looks rather good. It ensures that their deposits are protected not only now, but in the future. I pointed out in a previous post that small deposits are only protected to the extent that their sovereign can afford them (or to the limit of the amount that can be raised from other banks): but if large deposits and senior bonds can be bailed-in, deposit insurance should always be affordable - shouldn't it? That is, of course, assuming there are any. I shall return to that shortly.
The Bank of England's Financial Policy Committee has recommended recently that banks should have more capital. Contrary to popular opinion, capital is not "cash" - it is shareholders' funds. It is the difference between the bank's debt and its assets. And borrowing - of any kind, including from the central bank - is NOT "capital", except under certain circumstances that I shall explain. When banks have insufficient capital, they usually have three ways of creating more:
- they can issue more shares. In the first instance the share offer would normally go to existing shareholders - what we call a "rights issue".
Bank shareholders are now somewhat wary of rights issues. RBS famously did a rights issue in April 2008 to shore up its damaged balance sheet after the ABN AMRO acquisition. It failed less than 6 months later, and shareholders are now proceeding with legal action against RBS. Rights issues by damaged and undercapitalised banks would not be popular. And rights issues by partly-nationalised banks are a demand for more taxpayer money.
- they can retain earnings. This means that instead of dishing out profits to shareholders in the form of dividends or employees in the form of bonuses, they keep them. But that of course assumes that they are making profits at all. Not all banks are. And banks that are under pressure to recapitalise by retaining earnings don't necessarily give customers a good deal. They need to maintain a wide spread between interest earned on lending and interest paid on deposits, so borrowers are charged a lot and savers are paid little. We have seen widening credit spreads ever since the financial crisis.
- they can sell off or wind down portfolios of risky assets which need more capital. Or they can shrink their balance sheets, reducing both assets and debt, by selling off bits of themselves - for example, RBS's sale of the Direct Line insurance company.
This requires some explanation. Bank capital requirements as set by regulators currently use what we call "risk weighted assets", which are a way of assessing the relative risk of different types of asset. Without going into details, the effect of risk weighting is to require banks to have more shareholders' funds if their balance sheets are riskier. But the calculation of risk weightings is something of a black art, so there are numerous opportunities for banks to game the weightings and pass assets off as less risky than they actually are. Additionally, assets become riskier under certain circumstances: for example, prime mortgages become sub-prime as house values fall and interest rates rise. A large fall in house prices resulting in a lot of home owners having negative equity in their properties can render mortgage lenders insolvent due to the increased capital requirements for what are then in effect unsecured loans.
So clearly, if banks are short of capital, it is in their interests to reduce riskier lending. Unfortunately this tends to be the lending that governments like them to do - loans to small businesses, loans to first-time house buyers. Hence Mervyn King's directive that banks should increase capital "in ways that don't harm lending". I am struggling to see how this is possible. In the short-term, lending must either be more expensive (because of the need to retain earnings) or scarcer - or both. In the long-term, of course, increased capital enables banks to lend more to higher risks without putting depositors' money at risk. So a drive to recapitalise banks involves short-term pain for long-term gain.
Except in Cyprus. And possibly in the rest of the Eurozone too. Because the deal that has now been struck turns senior bonds and deposits over 100,000 Euros into contingent capital. Contingent capital is debt (bonds and deposits) that can be converted into equity (shareholders' funds). The UK's ICB has recommended that banks should, in addition to equity, hold a substantial amount of contingent convertible debt to provide additional protection to depositors in the event of a bank failure. There has been much discussion about bonuses being paid in the form of "CoCos" (contingent convertible bonds), and in Europe there have been some ideas about changing the legal status of senior bonds so that they can be bailed-in (converted to equity) if necessary. But no-one has ever suggested that deposits could be bailed in - until now. Suddenly the game has changed.
If this deal is used as a model for bank resolution in other countries as well, it means that Eurozone banks have suddenly acquired the means of recapitalisation in distress. But it carries much larger implications than that.
Firstly, it means that the only real deposits in banks are insured ones. All other placings are contingent shareholdings. That includes the liquid assets of businesses - used to pay suppliers and employees - and large amounts of funds in transit, for example during house purchase. People and businesses will have to think carefully about how they move large amounts of funds around in future, if they can be seized without warning and converted to illiquid equity.
Secondly, it means that the only real creditor of banks is the government. Deposit insurance is paid for by banks but is a government directive, and as we saw in the financial crisis, when the funding for deposit insurance is insufficient, governments step in to top it up with taxpayers' funds. In Cyprus, the top-up has been provided not by taxpayers but by bailing-in large depositors. A preference order has indeed been established for the resolution of banks, but it's not what might be expected: the order is shareholders, contingent capital holders (junior AND SENIOR debt holders and large depositors), government. Insured depositors are effectively creditors of government, not banks. But insured depositors are still at risk if there is insufficient contingent capital to bail out government AND government is so highly indebted that it cannot borrow more to make small depositors whole. They are last in the preference order, but that doesn't mean they are safe from a government default.
Could this happen? Well, yes, I think it could. Bailing-in senior debt and large deposits this time came out of the blue, giving little time for them to escape - although figures show that a large amount of money was withdrawn from Cyprus banks prior to the deal. But now the precedent has been set, and Dijsselboem made his incautious remarks about this possibly being a model for future bailouts (he was silenced of course, but the damage had been done), who is going to place large deposits in Eurozone banks, except at much higher interest rates? And who is going to buy senior bonds, except at a deep discount? By bailing-in large deposits and senior bonds in this manner - contrary to existing terms & conditions, and with very little warning - the Eurozone leadership may have ensured that banks end up more thinly capitalised, and with far higher funding costs. This places small depositors at greater risk - especially in countries where sovereigns are already highly indebted and suffering from reduced tax take due to falling GDP.
It also carries serious consequences for lending. In the Eurozone periphery, interest rates to households and businesses there are already much higher than they are in the core, and lending is scarcer. This can only get worse as banks are forced to raise interest rates to attract large deposits and buyers for senior bonds. And these countries are already in recession: investment is falling and GDP collapsing. If the credit crunch intensifies due to rising interest rates to borrowers, it will make an already bad situation much worse.
Even in Cyprus, the bailout does not look like a good deal: small depositors may have been rescued, but they will pay with their jobs and their livelihoods. But the economic collapse there was going to happen anyway. What is much more worrying is the effect on the Eurozone periphery. If large depositors and senior bondholders take fright because of this deal - which seems highly likely - the economic effects could be disastrous.
Sham guarantee - Coppola Comment
A failure of compassion - Coppola Comment
Dijsselboem, do remember that careless talk costs lives.... - FT Alphaville
and the rest of the excellent (and now very extensive) FT Alphaville "A Cypriot Precedent" series
Still crunching - The Economist