Is there life after a haircut of deposits?

Popular Bank resolution: too much, too late
The CPB became insolvent two years ago and should have been liquated then, if it could not be restructured to become a going concern. The big mistake was keeping the bank artificially alive through the transfusion of billions of euros in liquidity from ELA, which was ending up in the black hole of its operations in Greece. The ECB should have pulled the plug at least a year earlier.
The way that the Troika insisted on the resolution of the CPB was partially correct (perhaps liquidation would have been better) but it was clearly unfair to the unsuspecting depositors who kept their money at the bank assuming that our government, the Central Bank and the ECB knew what they were doing when they were lending their full support and unlimited resources to CPB for the past couple of years.

Bank of Cyprus bail-in: efficient and unfair
For the BOC, technically speaking, the bail-in was the internalisation of risks to the decision makers (depositors) who are the most effective agents in containing and managing them. As such it is an efficient way of dealing with the problem: it minimises the social cost and maximises the benefit by incentivising the bankers to assess and manage risks as to avoid future bank collapses. It is also fair, since those who benefit from the bank’s high interest rates, which are usually associated with high risks, pay for the rescue of the bank.
What makes the bail-in unfair in the case of Cyprus is the way it happened, without advanced warning to the depositors of BOC, as it has done since with the depositors of all other Eurozone banks, for whom the caveat emptor “depositor be aware” was issued by the Eurogroup: in selecting a bank , depositors assume the risk of losing part or all of their deposits if the bank has been making risky loans and investments in order to afford the high deposit interest rates.
It may be argued that BOC depositors should have known that only the first 100,000 euros were insured, but like the case of the Greek bonds, the conventional wisdom was that bank deposits and sovereign debt were not subject to haircut. It is unfair that relatively small depositors lost their lifetime savings and a big part of their provident funds, when the target was big foreign depositors with suspect sourcing of their money.

Fire-sale of banking operations in Greece
The sale of the Greek operations of the troubled banks was a very bad deal, which was concluded under duress without the proper preparation and without the use of competitive procedures to maximise the sale price. While the Troika wanted Cyprus to get rid of those operations as soon as possible to limit the systemic effects of the Cyprus bail-in on the Eurozone via Greece, they did not dictate the buyer or the price. We could have called for competitive bids and sold these operations to the highest bidder within days. However, under pressure and in the confusion of those days clear thinking did not prevail. In a rush to conclude a deal we put ourselves in the hands of a well-prepared monopsonist. As the only buyer, the Bank of Piraeus, exploited to the fullest the circumstances and the worse-case scenario of PIMCO, to obtain these operations at a fire-sale price, possibly a quarter or a fifth of the likely competitive–bid price.

“Extorting” compliance through ELA
The Bank of Cyprus will be hard-pressed to survive the 9-billion-plus euros of ELA transferred from the CPB in addition to the 2 bln euros of its own ELA. We should not forget that the ELA, as emergency liquidity lending, is a short term loan which needs to be repaid right away; this obligation is now renewed every two weeks. Second, ELA, as ECB money, has the first priority on any funds recovered from the sale of land and other bank assets used as collateral.
Restructuring of ELA into a long-term loan or converting it into bonds would help make the BOC viable but it is unlikely to happen since the Troika, and especially the ECB, is holding it as a bargaining chip, or a lever to “extort” compliance to the terms of the MoU and the loan agreement or future demands. A good solution would be to take over BOC by a reliable investor with global credibility, such as a major international bank, for whom the relative size of the ELA obligation is miniscule. The chances of this happening, however, are rather small.

Can the economy survive a BOC resolution?
In the unlikely event that the BOC goes into resolution again, the ramifications for the Cyprus economy will be severe in the short to medium run. First, there would be the losses to the shareholders, the lenders and the depositors in the tens of billions of euros. Then there will be the job loss for about 4,400 bank employees and the economy will go into a tail spin because of inability to carry out business transactions and the drying up liquidity. Even more serious will be the total collapse of trust in the Cyprus banking and financial system and the credibility of the state will hit rock bottom. The BOC is not only the country’s largest bank; it is also its largest single organisation, several times the size of the country’s GNP. It is a historic and systemic bank in which virtually every citizen and business has a stake.
The economy and the country can survive a BOC resolution over the long-run but the short-to-medium implications would be devastating and every effort must be made to ensure that the bank survives as the country’s systemic bank and plays its pivotal role in mobilising and allocating financial resources for the recovery and growth of the local economy. In this regard the contemplated split of BOC into a commercial and a property or development bank should be carefully studied and well prepared as it risks further loss of trust and credibility. Only non-viable land development projects should be sold as property to repay loans while viable projects should be financed to completion by foreign investors, given the immediate need for development and jobs and the paucity of development alternatives.

The new world of banking and finance
It is clear that the banking sector will shrink, not only in Cyprus, but throughout the Eurozone, and the role of banks in the financing of the economy will be reduced. The individualisation of responsibility and internalisation of risks and consequences to the depositors (along with the lenders and shareholders) will change the investment behaviour of the capital holders and will move funds away from banks. Reduced safety for depositors requires educating depositors and the general public about the risks they take when they choose where to put their money.
The interest rate should not be the only consideration; the risk must also be considered. For this, we need transparent indicators of risk. We also need indicators of the health of the institution, the quality of its portfolio, the capability of its management, and, the quality of its corporate governance. We also need transparent accounts and clearly understood financial statistics of both bank and host country.

Leaner, meaner banking
The closer supervision of banks and the reduction and regulation of their pay and bonuses will make banking a less profitable activity. The requirement for increase in capital adequacy to 9%+ will further lower the profitability of the banking sector; leveraging and incessant expansion will be contained. The banks will become tighter in their lending and businesses will seek funding directly from capital markets.
New ways and new instruments of financing will emerge, e.g. corporate bonds, trade bills, commercial paper, discount instruments, investment companies, and special purpose banks such as entrepreneurship and property banks, as it is the case in the US, where under 25% of the total financing comes from banks; the rest comes from other sources and financing schemes even if it is channelled through the banks.
The banks will stop lending with the main criterion of adequacy of the collateral (usually real estate) and they will be considering more seriously the profitability, the cash flow and the ability of the borrower to service the loan. They will be requiring of their borrowers detailed and well documented (with market research) business plans, and they will acquire the expertise to scrutinise such plans. The banks will get rid of their speculative mindset and concentrate on their socio-economic role as mobilisers and allocators of funds for economic growth and development, or this is what they should do if they want to survive.