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Bad resolutions

3 April 2013 By Hugo Dixon

The “resolution” of Cyprus’ banks is a bad joke. Resolution is one of the new buzzwords in financial regulation. The practice is supposed to stop taxpayers having to bail out banks, while imposing pain fairly on shareholders and creditors.

In Cyprus, Greek deposits and favoured groups at home are exempt from haircuts, while other groups of depositor are hammered even harder. It’s anything but fair.

The resolution of Cyprus’ banks doesn’t matter just for those directly affected. It is one of the most ambitious cases of cross-border resolution since the financial crisis began. So a bad result here is hardly a good advertisement for the technique.

The Financial Stability Board (FSB), which coordinates financial regulation on an international level, published a document in 2011 setting out how resolution should work. Important principles are that the hierarchy of claims should be respected and that creditors of the same class should be treated equally.

The basic idea is that shareholders should take the first hit. Only after they are wiped out should the next line of defence, junior debt-holders, come into the line of fire. Only if they too are destroyed should the senior creditors, such as other bondholders and uninsured deposits, get haircuts. Insured deposits should be protected.

In Cyprus, this good practice has not been followed. The big picture may look textbook: shareholders and bondholders in the two big troubled banks are being wiped out; uninsured depositors are being haircut; and insured deposits are being protected. But a series of exemptions for favoured groups and several merger transactions muddy the picture.

Cyprus’s two largest banks are Bank of Cyprus (BOC) and Cyprus Popular Bank, also known as Laiki. Both expanded rapidly, particularly in Greece, where they lost billions of euros after Athens restructured its sovereign debt. They also lost money by financing a property bubble at home. Of the two, Laiki is the more troubled.

The resolution has had four main elements: the banks’ Greek operations have been sold to Piraeus Bank, a large Greek bank; Laiki’s Cypriot operations have been split into a “good bank” and a “bad bank”, with uninsured deposits being converted into equity in the bad bank; Laiki’s good bank, along with its insured deposits, has been merged into BOC; finally, up to 60 percent of BOC’s uninsured deposits are being converted into equity in order to recapitalise it.

The first problem with this arrangement is that the euro zone insisted that Cyprus insulate Greece, a much bigger worry from a systemic perspective, from contagion. That left the Cypriot banks little option but to agree a fire-sale of their Greek operations.

Piraeus acquired assets with a value of 16.4-19.2 billion euros. It also took on 15 billion euros of deposits. At the mid-point of these two valuations, the Greek operations had a net asset value (NAV) of 2.8 billion euros. Piraeus’ purchase price of 524 million euros amounts to a pretty low 19 percent of that NAV.

When Laiki’s directors saw the deal negotiated on their behalf, they concluded the Greek branches had to be recapitalised by about 2.8 billion euros before being sold, according to Reuters. After the directors refused to sign, the central bank governor, Panicos Demetriades, signed on their behalf.

What’s more, the Greek uninsured deposits were excluded from the wider bail-in. The troubled banks’ Cypriot deposits equal 26 billion euros, according to Nomura. Assuming each country has a similar proportion of uninsured deposits, exempting Greek deposits from the bail-in meant that the Cypriot ones had to shoulder the whole burden instead of only 63 percent of it.

If the way the Greek operations were treated amounted to a wound inflicted from abroad, what happened next was self-inflicted. Cyprus exempted the following groups of depositors from the resolution of both banks: the government, municipalities, financial institutions, insurance companies, schools, universities, charities and the country’s main credit card processing company. As a result, others are facing extra pain.

To be fair, the FSB framework says resolution authorities should have the flexibility to depart from the principle of equal treatment for creditors of the same class to contain the systemic impact of bank failures – provided there is transparency over the reasons for doing so. But Cyprus hasn’t said why the groups it has singled out are worthy of special treatment.

Laiki’s “good bank” was then dumped on BOC. The term “good bank” implies it is an attractive operation. But good Laiki doesn’t just bring assets of dubious quality. It also brings liabilities: insured deposits; uninsured deposits exempted from bail-in; and Laiki’s entire 9.2 billion euros of estimated emergency liquidity borrowings from the central bank.

It’s hard to assess the value of this package of assets and liabilities given the dearth of numbers. But it would not be surprising if the value was negative. What’s more, all the Laiki liabilities being transferred take precedence over the BOC deposits that are being bailed in, meaning the latter may end up being thwacked more than is fair.

A few billion euros here and there may not sound a lot of money. But Cyprus’ GDP is only 18 billion euros. The massive haircuts will drain money from the local economy, plunging it into a slump.

The principle that shareholders and creditors rather than taxpayers should pay to bail out banks is a good one. But the way this resolution has been conducted makes a mockery of the concept.


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