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Was the Cyprus bail-in fair?

02 April, 2014

By Stavros Zenios
Posted on www.zenios.wordpress.com   

I argue that the Cyprus bail-in failed some important tests of fairness. This is highly relevant given the provisional agreement reached between the European Parliament and the Commission on proposed Single Resolution Mechanism for the Banking Union on the 20th of March.

The bail-in of depositors was considered by the Troika essential, if the country were to avoid unsustainable debt levels. Therefore, by restructuring bank liabilities the country avoided the risk of debt restructuring or default. This was a typical example of creditors and debtor working together to avoid default -creditors are the bank depositors and debtor is the bank- and the Principles for Stable Capital Flows and Fair Debt Restructuring should have applied . These principles incorporate voluntary, market-based, flexible guidelines for the behavior of debtors and creditors with a view to promoting and supporting financial stability.

While they are not legally binding they have been proven effective in dealing with sovereign debt restructuring. Until October 2010, the Principles applied only to sovereign issuers in emerging markets, but their applicability has since been broadened to encompass all sovereign issuers, as well as cases of debt restructurings by non-sovereign entities in which the state plays a major role in influencing key parameters of debt restructurings. They should have applied to the restructuring of bank liabilities, as this was an agreement involving an intergovernmental group (the eurogroup), the Cyprus parliament (legislature) and the Cyprus government (executive).

The Principles rest on four pillars: (i) transparency and timely flow of information; (ii) close debtor-creditor dialogue and cooperation to avoid restructuring; (iii) “good faith” during debt restructuring and (iv) fair treatment of all parties. In the Cyprus bail-in, pillar (i) was not satisfied as the decisions were based on confidential studies by PIMCO and KPMG. Pillar (ii) was satisfied as the Steering Committee for the PIMCO study involved all the key actors. “Good faith” was not questioned by any of the participants of the Steering Committee so one may consider pillar (iii) satisfied as well. However, Bank of Cyprus (BOC) that was to assume the burden of Laiki ELA was not consulted, its executives questioned the fairness of the deal, its Board refused to approve the deal and resigned in protest, and the deal was signed by the Governor of the Central Bank of Cyprus in his capacity as resolution authority. Therefore pillar (iii) was not satisfied in dealing with Bank of Cyprus.

Furthermore, treatment of various stakeholders in the new BOC was not equitable. In particular, the bailed-in depositors of BOC contributed €3,806mil. in cash and received 3.806mil shares, i.e. €1.00 per share. Laiki contributed net assets €425mil. and received 844mil shares at €0.503 per share. The capitalization of the old shareholders of BOC was €371,95mil at the time of restructuring and they received 18mil shares at €20,66 per share. If all stakeholders were given shares at the same price in proportion to their capital contribution, the capital structure of the restructured BOC would have been 82.7% bailed-in depositors, 9.2% ex-Laiki and 8.1% old BOC shareholders. Instead, the current allocation stands at 81.5%, 18.1% and 0.4% respectively. This is preferential treatment of ex-Laiki at the expense of old BOC shareholders. Of course, old shareholders expect to be wiped out in case of bankruptcy. However, the bank was restructured and not resolved –i.e., there was no bankruptcy- and therefore they should have been treated equitably with ex-Laiki, even as BOC depositors got preferential treatment, as they should have.

Therefore, fairness pillar (iv) was not satisfied. In a perverse twist of events, while the bail-in process failed the transparency test, at the same time it created transparency when opacity is required: With BOC shares returning (hopefully) to active market trading, the bank ownership needs to be disclosed. Since a very large proportion 81.5% of the shares is owned by the bailed-in depositors, any disclosure of share ownership allows us to infer the amount bailed-in from each shareholder. This is tantamount to public disclosure of deposits prior to the crisis, in violation of banking privacy rules.

How is the analysis relevant for Cyprus today?

The provisional agreement on the Single Resolution Mechanism clarifies bail-in procedures. Several exceptions to depositor bail-in are envisioned –for short-term deposits, payments for products delivered, pensions and wages. None of these exemptions were applied in the Cyprus case. Needless to say, these are the exceptions that would have mostly alleviated the severe credit crunch Cyprus is experiencing. In spite all the encouraging rhetoric, growth with credit crunch is a myth –as University of Cyprus colleague Marios Zachariades tweeted recently. Someone –the ECB, the EC, the Eurozone- should make amends for the botched bail-in. This editorial offers some dis-passionate arguments as to why. As to the “how” I repeat my favorites: Extend liquidity to Cyprus banks so capital controls can be lifted and provide financing for a bad bank
It is arguments, not passions, that we need in Europe. And this is one reason I have thrown my hat in the eurorparliamentary elections race -but this is another story.