.
Marcuard's Market update by GaveKal Research
One of the many unanswered questions surrounding the eurozone has always been—who would pay for systemic large losses in a banking system? In the US, we always knew that the federal government, through the insurance payments levied via the FDIC, would guarantee all small depositors. In Europe meanwhile the eurocrats issued a post-crisis pan-European promise that every deposit up to €100,000 was guaranteed; even if it was left unclear who would pay for that guarantee in a time of crisis. Then the Cyprus crisis occurred and on first attempt the eurocrats tried to backtrack on the €100,000 promise. Given the uproar, they backtracked again (the eurocrats are nothing if not flexible with the rules) and came up with a very European solution: soak the rich!
So we now know that, in Europe, big depositors are the first in the line of fire to ensure that small depositors do not suffer losses. Needless to say, this raises the question of who wants to be a big depositor in a weak bank in a country undergoing a secondary depression
This “soak the rich” option also makes one wonder whether the EU is now blatantly against the financial industry? This is a very important question for, in any country, the banks and the government are de facto joined at the hip, dependent on one another to deliver a stable outcome for the underlying economy. However, in the past month, it seems that the EU has opened a multi-front attack on the financial industry. First, there was the EU laws against bank bonuses. Then came the proposals to also cap the bonuses of UCITS fund managers (as everyone remembers the 2008 crisis was triggered by all the cowboy unit-trust managers, doing such things as buying and selling stocks and bonds!) And now, in the past week, EU policymakers have cheerily taken down an offshore banking centre? This is not a comforting pattern.
EU policymakers are probably not evil henchmen set on destroying the financial industry (even if it often looks that way from the City of London). The more likely explanation is that EU policymakers are simply ignorant of how financial markets work. For example, the fact that the two largest Cypriot banks’ London branches have remained opened through the past week, allowing large depositors to take out millions of euros, hints that Europe's policymakers are simply clueless when it comes to how financial markets work. This also means that whatever pound of flesh the EU thinks it will be getting by wiping out the large depositors could turn out to be on the light side.
Or, for a second example of cluelessness, what could rival Monday's declarations by the Dutch finance minister that the Cyprus bailout set a new “template” on how to deal with bust banks, namely make the rich depositors pay for the little depositors? What large depositor in a troubled bank in a country going through a secondary depression will want to stick around for that deal? We would venture that the next time that "solution" is applied, the eurocrats will find that the large depositors will not have waited around to get fleeced. In fact, as mentioned above, it might not even work this time (i.e., Cyprus), let alone the next one.
Going one step beyond the ignorance of how financial markets work, what seems profoundly shocking is the lack of recognition of this ignorance. Place yourself back in the fall of 2008. As the financial crisis was unfolding, the likes of John Mack, Jamie Dimon, John Thane and other banking heads were asked to meet at the New York Fed, the US Treasury or even the US Congress on a regular basis to explain what was unfolding (and what they planned to do about it). Meanwhile, how many times have the heads of Santander, Intesa, SocGen, Deutsche Bank, etc., been called in to explain what was going on, or for them to give their views on what should be done? If asked, perhaps these CEOs would have said that:
a) European banks are much more dependent on deposits then their US counterparts.
b) Owners of large deposits are likely to be more risk averse and much more active in moving their money than small retail savers (for whom moving money from one country to the next presents high costs and almost insurmountable hurdles). And this for obvious reasons: a 40% haircut on $1,000 is unpleasant but it's not going to change anyone's life. But a 40% haircut on a pensioner's life savings of $500,000 will have a huge impact—and a 40% haircut on any middle-sized company's $10mn payroll will be enough to bankrupt the business. In fact, this simple reality brings us back to Mark Twain's advice that it is always better to tax poor people as there are so much more of them—unfortunately, Europe keeps going the other way, with devastating consequences.
c) For these reasons, regulators and governments have never in living memory allowed big banks to default on their depositors, regardless of the wording of formal deposit insurance contracts. If this implicit guarantee is now removed in Europe (and it sure looks like it has been), then we should expect a big shift of large deposits out of the banks and into government bonds or credit market instruments.
d) This will prove very problematic, especially given the new Basel III regulations which encouraged a funding model whereby banks should rely more on deposits and less on bonds.
e) As savings shift out of banks and into credit markets, the "German bank" model based on bank-financing of industrial companies and long-term creditor-debtor relationships will inevitably erode, to be replaced by the Anglo-Saxon model credit-market financing along with the short-termism which it implies.
In other words, the law of unintended consequences is at work: the eurocrats will end up with exactly the opposite of the financial system they wanted. Either that, or the European banks will end up having to be nationalized in great numbers. These two possible outcomes seem to be the logical consequence of the EU's very unfriendly financial sector policies.
Disclaimer: This information may not be construed as advice and in particular not as investment, legal or tax advice. Depending on your particular circumstances you must obtain advice from your respective professional advisors. Investment involves risk. The value of investments may go down as well as up. Past performance is no guarantee for future performance. Investments in foreign currencies are subject to exchange rate fluctuations. Marcuard Cyprus Ltd is regulated by the Cyprus Securities and Exchange Commission (CySec) under License no. 131/11.
