A failure of compassion

The deed has been done. A deal has been struck to wind up Laiki Bank and restructure the Bank of Cyprus. Deposits of less than 100,000 Euros are protected from loss, as are deposits at other banks. Deposits of over 100,000 Euros are frozen and will be seized in part or whole to pay the debts that Laiki Bank and Bank of Cyprus cannot pay - including the money lent to Laiki Bank by the ECB to keep it going even though it was obviously insolvent.

So Cypriot taxpayers and small savers are off the hook. Popular belief has it that those who will pay are rich Russian oligarchs, who are probably criminals and tax evaders and therefore deserve what is coming to them. Tax campaigners claim that as Cyprus was a tax haven, the destruction of its banking sector is only just and fair. Small savers across Europe breathe a sigh of relief at the news that their deposits are safe. Larger depositors cling to the Eurogroup's assurance that Cyprus is a "special case" and this will never happen anywhere else - despite Dijsselboem's  incautious remarks about the Cyprus deal forming a basis for other bailouts.

None of this is true. There is no justice in the Cyprus deal. Everyone in Cyprus, and many people in other countries, will pay - for what is in fact a sovereign bailout.

Let me explain. I noted in a previous post that the Cyprus government could not afford to pay deposit insurance claims in the failed banks. To do so would have raised their sovereign debt/GDP ratio to an estimated 145%. The IMF regards this as unsustainable, so would not have contributed to the 10bn Euros bailout fund, which would have left the Euro area governments funding all of it. Clearly the Eurogroup wants all the IMF funds it can get, so the burden doesn't fall too heavily on Euro area countries many of whom are already in difficulties themselves. So a solution that forced the IMF to withdraw would be unwelcome. The first proposed solution involved partial failure to honour deposit insurance. This was rejected by the Cypriot parliament - foolishly, as I shall explain shortly. But also fortunately, since if it had been accepted it could have sparked bank runs across Europe. The final deal ensures that deposit insurance can be fully honoured without raising sovereign debt/GDP to unsustainable levels.

But note who is responsible for the payment of this deposit insurance. It is a SOVEREIGN responsibility. Yes, banks pay a levy for it - but if the claims exceed the amount paid in by banks, the sovereign then meets depositor insurance claims from general taxation. In that way it is like other "pay-as-you-go" sovereign liabilities such as pensions and social security. National Insurance in the UK is a good example of a supposed "insurance fund" that doesn't exist in reality: people "pay in", but the money is spent on existing obligations and any future claim they make has to be met from future contributions by others. That's how deposit insurance works too, at least for large claims.

So this is a SOVEREIGN bailout. Large deposits have been raided to pay the deposit insurance on smaller deposits that the sovereign could not afford to pay. It is correct to describe the large deposits seizure as taxation. It is absolutely incorrect to suggest, as some have, that it establishes an order for creditor payouts in the event of a bank failure. There has been no change in preference order: large deposits still rank pari passu with smaller deposits and with senior bonds. What this has done is establish a precedent for a sovereign to seize large bank deposits to enable it to meet its obligations.

So why is this unjust? Why was the Cypriot government foolish to reject the original proposal? Isn't it only fair that the rich should pay?

I would be the first to agree that those with the broadest shoulders should bear the largest burden. But that isn't what is going to happen. The large deposits that have been frozen don't just belong to rich Russians. They also belong to Cypriot businesses - who needed that money to pay wages and suppliers. They belong to Cypriot households - who saved that money to buy houses and pay for their children to go to university. They belong to charities, and educational foundations such as the University of Cyprus. They belong to UK citizens who have retired to the sun. They belong to hard-working Russian businesses and households who placed their money in those banks because of fear of expropriation of those funds by their own corrupt and predatory government. They belong to anyone, anywhere, who thought that Cypriot banks offered a better deal on interest rates than their own banks. The fallout across Europe will be considerable. A lot of people stand to lose a lot of money, and most of it isn't "laundered" as some people have claimed. If there was criminal money in Cyprus banks - and there may well have been - most of it probably left long before the crisis hit and is now safely stashed away in Malta, or Latvia, or Cayman. As always with catastrophes of this order, the burden falls on those who can't escape - ordinary hard-working families and businesses.

And that's why the Cypriot parliament was foolish to turn down the original bailout proposal. It was actually the best deal for small depositors. Yes, they would have lost some money. But now they will lose their jobs, their businesses, their livelihoods. Businesses whose liquid assets are frozen will go bankrupt. Shops will close - particularly those whose main business lines were aimed at Russian visitors. Households will be forced to cut back spending. People - especially the young - will struggle to get even basic jobs. Nor will the banking sector be able to provide much in the way of financial support for hard-pressed businesses.  The windup of Laiki Bank leaves a very large hole in Cyprus's banking sector, and the restructured Bank of Cyprus will be in no condition to lend for some time to come - if it survives at all. For the truth is that this is only the first bailout. As we saw with Greece, one bailout leads to another as GDP collapses. And make no mistake, Cyprus's GDP is going to collapse. Massively.

As we know from the financial crisis, the failure of a large part of a country's banking sector is devastating for its economy. And Cyprus is already in recession due to fiscal consolidation and a nasty downturn in the manufacturing and construction sectors. The economic disaster facing Cyprus is of a similar order to the collapse of former Iron Curtain economies after the breakup of the Soviet Union. Latvia's GDP fell by 20% in 1990-91. Some analysts estimate the fall in Cyprus's GDP as a direct consequence of this deal at -10% this year and maybe another -8% in 2014. It could well be more. And the burden of such a disaster will fall most heavily on the ordinary people of Cyprus. The raid on large deposits will actually be paid for by the small depositors it was intended to protect.

So should we feel sorry for Cypriots? Well, not everyone thinks so. In a conversation yesterday, an anti-poverty campaigner expressed a view that as Cypriots are not poor compared to say people in Malawi, what happens to them doesn't really matter and we should be addressing the needs of the REAL poor in other parts of the world. To me this misses the point. Ordinary Cypriots whose lives will be devastated by the forthcoming economic collapse are the "real poor" in exactly the same way as the poor in sub-saharan Africa. The causes of their poverty are the same: corruption, greed and selfishness among the rich and powerful, paid for by the (relatively) poor and powerless. It is merely a matter of degree.

But I am even more disturbed by the attitude of tax justice campaigners, rejoicing at the closure of a tax haven. They approve of the demolition of the Cypriot financial industry, and look forward to the same treatment for Malta, Luxembourg, the Netherlands and Ireland. The effect on the lives of ordinary people in these countries apparently concerns them not at all: some even suggest that as Cypriots have benefited from inflows of hot money, they should now pay for living off the proceeds of crime. I am horrified by such a failure of compassion. There have been calls for Cyprus to have "transitional relief" as it struggles to reorient its economy away from financial services. To their credit, the Troika recognised that Cyprus's economy is in deep trouble and announced in their press conference that they would send in a "task force" to help restructure the economy to generate jobs and growth. But will it provide financial support? I doubt it. Compassion is in short supply in the Euro area.

The view in some circles that Cyprus deserves what is coming to it is not lost on Cypriots themselves. And they are anxious to set the record straight. As one man put it in an email to me:
"We are not idiots. We know that we are to blame. We, the people and our corrupt politicians. But to be treated like this……! you do not murder a family if a kid is misbehaving.  Whole generations of Cypriots, their lives and future have been destroyed......"
So those who feel strongly about justice and poverty, think again. Ordinary Cypriots are not to blame for this crisis, but they are the ones who will pay. They deserve our compassion and our support.

Related links:

Sowing the wind - Coppola Comment
Sham guarantee - Coppola Comment
The broken Euro - Coppola Comment


  1. It is more than simply a failure of compassion. It is ultimately self defeating. The IMF wanted a sustainable debt path. How does this achieve a sustainable debt path? Overnight liquid wealth has been reduced by 2/5 of GDP. The economic shock is unprecedented in peacetime. The service sector has been dealt a death blow. Further austerity will crush civil service pay and employment. the Cypriot middle class is decimated. The impact on GDP and tax revenue will render the IMF estimates of debt sustainability redundant by the end of this weekend. The 10 billion will not be enough and Cyprus will need a second rescue. where is the sustainable debt path? the troika action has sent Cyprus on an ineviatable if unwelcome euro exit.

  2. You may have seen this commentary on the role Germany has played in this affair - curiously in Der Spiegel:


  3. I don't disagree that ordinary Cypriots deserve some compassion, and help, but still some nitpicking:

    - deposit insurance being pay as you go: only true for some schemes and for large failures, some countries definitely keep the levies in ring fenced funds that are enough to cope with small failures (I assumed that was also the case for the FSCS, that is that they funded rescues the size of say Worldspread with levies rather the Treasury or BoE funding). This is important as it's one of the issues that slows down a full ECB-backed guarantee: how to unwind these funds without causing a loss of trust, and without penalising the virtuous institutions who contributed to them. This is a technicality, but a tricky one.

    - dirty money will have gone away: this assumes Cyprus did not have uniquely lax compliance standards within the eurozone. I don't know, but it's what reports seem to indicate. Let's go through your proposed alternatives: Malta seems cleaner with a local banking system which shouldn't get involved much with that stuff, and subsidiaries of big international institutions which should apply their (higher) home standards; Latvia, well given the historical tensions between the Baltics and their former masters, it sounds somewhat far fetched that Russians would trust people who hate them with their money; and Cayman, it serves a different need not being in the Eurozone. Also I suspect the same reason that explains the lack of wholesale peripheral bank run (ordinary people not digging macroeconomics) also applies to the typical dodgy Russian.

    - some large savers were good/honest people: no doubt there are some, but we're lacking a quantification of the phenomenon. Is it 1%, 10%, 50%, 75% of the uninsured deposits? The smaller the percentage, the more the haircut is fair, and the easier it is to help these people via other channels.

    - as for those "who thought that Cypriot banks offered a better deal on interest rates than their own banks", I can't believe you're defending these didn't deserve a haircut! People need to learn not to invest in too-good-to-be-true schemes and get burned on occasion if they do, for pedagogical reasons if nothing else.

    - cash-rich SMEs: do they exist? Most small businesses anywhere in the world tend to live on overdrafts rather than cash piles, I wonder if the extent of the damage here is as big as feared. More generally, if they're lucky some new operators (the smaller Cypriot, or Turkish banks?) may jump in and catch the opportunity opened because of the incumbents' withdrawal from SME banking.

    - that legit businesses who catered to Russians will fail is unfortunate but unavoidable. If someone runs a sweet store and most of their customers are burglars, you can't ask the government to support the burglary industry in perpetuity to avoid penalising the innocent sweet store owner. All you can do is help the store owner find a new job or a new clientèle.

    1. 1) I was specifically talking about the Cypriot scheme. The Cypriot PM made it very clear that meeting depositors' claims would bankrupt the state. Therefore the scheme is underfunded to the point of being useless. It is de facto an unfunded state liability.

      2) There is not much evidence for the "lax compliance" meme. It seems to be the Cypriot equivalent of "lazy Greeks" - popularly believed, and used by politicians to justify harsh treatment, but when you actually look into it the truth is rather different. See this link from Naked Capitalism (not usually known for defending corrupt banks): http://www.nakedcapitalism.com/2013/03/repeat-after-me-cyprus-is-was-not-a-tax-haven.html

      I seriously doubt if Malta is any cleaner than Cyprus, and my spies tell me that Latvia is now the haven of choice for the rouble zone. Cayman was a wild shot, I agree - maybe I should have said Luxembourg. Other tax havens, anyway. That's the point.

      3) We have no quantification. But as these two banks are a large proportion of Cyprus's banking sector, and Cyprus does have other industries and a reasonably well-off population, I would expect that a sizeable portion of the large deposits are not only legitimate but domestic. There is zero chance of them being "helped via other channels". On the contrary - they will go down with the ship. There are no lifeboats or even life jackets being offered.

      4) I am pointing out that the fallout from this decision is widespread, not limited to Cyprus or to Russia. It is up to individual governments what they choose to do to protect their own savers. Personally I think people need to learn that there is no such thing as a free lunch. But I'm interested in the economic consequences of this deal, which in my view go far beyond Cyprus.

      5) Yes, cash-rich SMEs do exist. But remember that this deal includes current accounts. It wouldn't have to be a very large business to have over 100,000 Euros in its current account from customer payments or in transit to suppliers or employees. Those people now won't be paid, and customers' money will have been lost.

      Clearly there will be new entrants into the banking sector. But that won't compensate these businesses, or their suppliers, or their employees, for their losses.

      6)Russian does not necessarily mean criminal. Really there is so much anti-Russian rhetoric going on it borders on racism. Legitimate Russian money has been seized: legitimate Russian businesses and households now will think twice before placing funds in Cyprus. So much for FDI.

    2. On (3), "help via other channels" is, generally, always available. Basically if we generalise a tax (or tax-like action we have here) can always be selectively compensated by a government subsidy or tax rebate elsewhere. Unless you give the subsidy to exactly 100% of the tax base, you can redistribute. The Cypriot government could try and identify worthy haircut victims and treat them favourably compared to the less worthy. As this is relative (wealth is rank!) this remains to some level possible however limited the absolute resources are, the only requirement is to have >1 taxpayers (you can't rank a singleton).

      (5) I'd expect an SME's current account petty cash to often come from a bank loan from the same bank. Now the problem is obvious if the haircut is done on the petty cash while the loan remains outstanding, but it's a fixable problem if they wished to (even retroactively, e.g. they could accept the bank shares they get in the haircut as settlement for the loan at the notional haircut price, or something like that).

      (6) well in a plutocratic state without private property to speak of, I doubt many can become wealthy in a fully legitimate way and then squirrel their money to, of all places, Cyprus, which has had "DODGY" written on it in big letters for decades... I wouldn't use the term criminal though, having the favour of the King is not as such criminal (literally so, the King is the law!), but nor is it legit or fair in a Western sense. As your theme was compassion, I don't think Russian courtiers deserve it.

    3. Good points, CIG. Compassion yes, in terms of helping Cyprus restructure it's economy to more substantial sectors.

      As for "greek mentality"...well, I live in a central european country, and I remember, even back in the mid-90s, our economy teacher in high school was explaining to us that in Greece, everything is pretty much done through the black market. Back in the 90s. High school teacher.

      A country that has ballooned it's banking sector to such a point as Cyprus has, has very little room for "compassion" left now, all that's pretty much left is hard-earned lessons ahead.

  4. Hi Frances,

    While I am thinking that what is happening in Cyprus is of the utter most disgust for its population, I am not surprise. Already during the runner up of the Euro inception, I could sense that “something wasn’t right and will ended up in tears”, my suspicions were later confirmed by an article in the years 2000 published by the Diplomatic Courier intituled the” Crash of the Euro”. Former President Václav Klaus express clearly my views in this interview http://www.youtube.com/watch?feature=player_embedded&v=MBay8O5Od7o&list=PLmvYvlekX2OeMc_63F7gXJFeNL-FwqE6x

  5. Only because this is your most recent post, I will use it to applaud your performance on 'Today' this morning. It was the first time that I have heard anyone dare to defend the Bank of England (and, by inference, the Governor) against the barrage of ignorance that has been aimed at it since 2008. I have taken every opportunity to correct the popular view, in both comments and conversation, but nobody in interested in the counter-view.

    Gordon Brown's characteristically ill-thought-out reform of the regulatory régime was always a disaster in the making, as glaringly obvious a mistake as was the Euro. While the Bank of England had regulatory oversight of the banks, they were constrained by their responsibilities to the Old Lady. Threadneedle Street saw all the numbers, and was staffed by people who were at least as clever as those they regulated. They were able to detect problems first, and 'a quiet word' was all that was needed. External frauds were averted, while internal fast ones and funny business were stopped dead in their tracks. BCCI only happened because the BoE did not have a full picture of the bank's finances.

    Handing over banking regulation to the Keystone Gestapo of the FSA meant that the banks were overseen by inexperienced, under-educated, underpaid inadequates who only knew how to monitor building societies and pension funds.

    Vitally, banks were staffed by bankers, not by jumped-up accountants and marketeers like Fred Goodwin and Andy Hornby. They duly ran rings round the FSA, which was unable to rein in their absurdly vain global ambitions. It is significant that the bank which was run by bankers, dear old Lloyds, was only brought down when and Eric Daniels had a gun put to their heads by (yes) Gordon Brown, and effectively ordered to take over the disgraceful, irresponsible mess that was HBOS. It is a gross injustice that those two men are, in the popular imagination, bracketed alongside Fred the Shred.

    I trained as a stockbroker, not a banker, but I saw enough of the Old Lady in action to have been profoundly impressed by her. I can only hope that, in due course, a properly revisionist history of the crisis will put the majority of the blame where it belongs, firmly in the laps of Gordon Brown and his acolytes, and will vindicate Sir Mervyn King and his colleagues, who have been disgracefully traduced and misrepresented in a concerted campaign to whitewash the politicians.

    1. Wow. Many thanks. :)

      I'm not quite so impressed with Mervyn King. I think he got monetary policy wrong in the mid-2000s and didn't pay enough attention to financial stability as a separate remit from inflation targeting. And the Bank of England has had some spectacular failures of supervision - notably Barings and BCCI. But in general it makes sense to me that the regulation and supervision of the financial industry (not just banks) should be the responsibility of the body that is responsible for financial stability. You can't manage financial stability effectively if you have no control over the financial industry.

    2. Webwright’s point is backed up by what Mervyn King said at the 6th March session of the Banking Standards committee hearing. He said:

      “I was surprised at the degree of access of bank executives to people at the very top. And it was certainly easier access to people at the top than the regulators had. I remember before 2007 that the only time there was a speech about regulation from the prime minister was when there was an attack on the FSA for over-regulation. That was the climate in which regulators were operating then. It was extraordinarily difficult. They knew that if they were tough on a bank, the chief executive would go straight to No 10 or No 11 and say this is an attack on the UK's most successful industry, even when it was a perfectly reasonable application of the regulations.Times have changed clearly since then. But the access probably hasn’t..”

    3. " It is significant that the bank which was run by bankers, dear old Lloyds, was only brought down when and Eric Daniels had a gun put to their heads by (yes) Gordon Brown, and effectively ordered to take over the disgraceful, irresponsible mess that was HBOS."

      Any evidence?

  6. Yebbut, the Bank was fighting a losing battle from 2001 onwards, after the introduction of the exciting new regulatory structure, and with the Keystone Gestapo being (initially) chaired by that ineffable, over-promoted buffoon, Howard Davies. I wrote to him with stone-cold evidence of serious 'misconduct' there, and am still waiting for the courtesy of a reply. I think I should probably give up now!

    As I said, BCCI was hardly a BoE failure, as it was a complex fraud based overseas in several jurisdictions for maximum opacity, and the bank had a thoroughly corrupt management structure. Similarly, Barings was a problem rooted entirely overseas, outwith the BoE's remit; a complete failure of Barings' own management, certainly, but not really the Old Lady's fault.

    When all is said and done, until Northern Rock there had not been a run on, or failure of, a British bank for a hundred-and-oatcake years, and the reason for that is, in my view, the close scrutiny under which they were put by the Bank, before the creation of the FSA. I look forward to it being reinstated.

    Furthermore, you rather answer the misgivings of your first sentence in your last.

  7. I've seen before this claim that Lloyds was somehow forced to take over HBOS, but never a shred of evidence for it. Victor Blank in particular seems to have been keen to do the deal: he told Robert Peston nearly a year later "When we announced the deal in the middle of September, it did not feel like a rescue of HBOS, it felt like a wonderful opportunity that was available and would only have been available in adversity"

  8. Economics in many ways is only a proxy measurement for energy consumption. Where there is a high consumption of energy, there are developed economies.

    too big to fail


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