Who was to blame for the ten days that rocked the eurozone?

This time a year ago it looked like Cyprus was on the verge of falling out of both the eurozone and the EU. In the end that did not happen; but only just.
Plenty of Cypriots believe that the Cyprus crisis was cooked up by foreign powers in order to grab the offshore natural gas.
But the real reason was a confluence of many inter-related causes: the banks, the local and international regulators, Cypriot and other governments, the rating agencies, Cypriot and EU politicians, the media and, one can argue, the Cypriot professional services sector.
So let us start at the beginning, with Cyprus’ entry into the EU in May 2004.

Eurozone entry pushed up deposits…
Until Cyprus joined the EU, the small island with an open economy had protected it its own currency with capital controls. This had the perverse effect of encouraging people to keep money abroad.
Eurozone entry was at first good for the banking system. Deposits came rolling in, rising from EUR 38 bln in 2005 to peak at EUR 70.2 bln in 2012 (Chart 1).
The common assumption is that these deposits came from Russia. But the data show that the biggest increase was from residents.
Of course, some of these could have been resident Russian companies. But one of the key attractions of the Cypriot tax system is the tax regime for non-resident companies.
Therefore it is not clear that Russian deposits were the reason for higher deposits. Perhaps EU entry helped Cypriots feel more secure against further Turkish incursions, so they brought their money back. 

…so banks started lending heavily…
Flush with deposits and enjoying lower interest rates because of forthcoming adoption of the euro, the banks started to lend heavily to customers. Housing loans rose by an astonishing 31% in 2006, 22% in 2007 and 29% in 2008 and 22% in 2009—a year after the Lehman Brothers collapse—and it seemed that everyone had a second property in Protaras. House prices rocketed as a result.
The Central Bank of Cyprus (CBC), which had already de facto lost control of interest rates as soon as Cyprus entered the Exchange Rate Mechanism in May 2005, merely fiddled at the edges, raising the amount required for down-payments on mortgages. But it did little else to stop the gush.
I confess that I am not sure if it even had the tools to do anything significant. Central banks all over the world at that time were stuck on the shortsighted mantra that their role was to protect the stability of consumer prices. They paid little attention to hyperinflation in asset prices.
Not surprisingly, these developments led to a rapid rise in household debt (Chart 2). 

…then there was excessive concentration of risk in Greece…
The warning signs should have come as early as 2008, when loans exceeded deposits for the first time. Prior to that, Cypriot banks had engaged in the good old-fashioned practice of lending less than they had on deposit.
But with EU membership in their pocket, they tried to get “sophisticated”, expanding their operations to Greece, as well as Romania, Russia and Ukraine.
Worse still, as profits from lending to Greek companies and individuals started to fall, the banks tried to make a fast buck. They invested heavily in Greek government bonds, convinced that the EU would never let them go sour.
This, as it turns out with hindsight, was the biggest single mistake of the banks and the primary cause of the crisis.

…supported by mistakes of the regulators and rating agencies…
Mistakes by the banks were not helped by Basel II regulations that allowed banks to put a zero risk weighting on bonds lent to other governments in the same currency area, even when they were heading for trouble.
Rating agencies were also arguably rather slow in downgrading Greek government debt to junk status. Moody’s Investor Service, for example, started to downgrade Greek government debt in December 2009. But it took another six months to reach junk status, by which time Laiki and BOC were heavily invested in Greek government bonds.
But one cannot just blame international regulations and rating agencies. To underline quite how nuts it was to lend so much to Greece, take a look at the amount lent to Greece compared with the banks’ capital at the time (Chart 3).
Yes, that’s right. Marfin Popular Bank (Laiki) lent more than its Core Tier 1 capital to the Greek government and Bank of Cyprus (BOC) lent nearly all of it.

…ending in the Greek PSI (haircut) that wiped out Laiki’s capital
Meanwhile, talk of a “private-sector initiative” (PSI/haircut/write-off) of Greek government bonds started to circulate. Estimates rose from 25% to 40% and more.
But the Cypriot political leadership seems to have been ignorant of the consequences, not least because communication between the then Central Bank Governor, Athanasios Orphanides, and the then President, Demetris Christofias, had broken down.
So the President agreed to the Greek PSI without making the case about its impact on little Cyprus. (Whether he would have been heard is something we shall never know).
The consequences were catastrophic. When the decision was taken in late 2011 to write off around 75% of Greek government debt, it wiped out nearly all of Laiki’s capital and much of BOC’s too (Chart 4).
Should the banks have seen the PSI impact coming? You bet they should have. The Financial Mirror published my estimates about the impact of a 40-50% haircut as far back as April 2011 (and what a lot of flack it got from the banks as a result).
But it seems that the boards were stuffed with people who did not have a clue. Here is what Alvarez and Marsal said about BOC: “Some of the Non Executive board members did not have banking experience, exceeded allowable credit facilities with BOC, and appear not to have received adequate training to fulfil the role”.

Mistakes by the government amplified the problem…
Laiki was technically insolvent. But the government did not have the funds to bail it out. It had turned the 3.8% budget surplus it inherited into a 6.4% deficit by 2011, because it jacked up spending as revenues from the property boom fell.
So, by the time the PSI happened, and partly because of market anticipation of it, the Cyprus government could not access international markets to bail out Laiki.
So it “borrowed” EUR 1.8 bln from Laiki to bail out Laiki. That debt (now to BOC) has not yet been repaid, and rises every year when it is rolled over.
Then, now infamously, the government failed to sign the bailout deal. As a consequence, Laiki got sicker and sicker, depending more and more on the CBC for Emergency Liquidity Assistance (ELA).

…as did mistakes of the central banks…
Supporters of the European Central Bank (ECB) will tell you that the decision for ELA is that of the national central bank. The ECB merely rubber-stamps the approval. In other words, it is technically the fault of a central bank if it continues to finance a bank that is insolvent.
But that argument comes unstuck when you remember that the ECB threatened three times to pull the plug on Laiki’s ELA: once in November 2012, which led President Christofias to agree in principle to the Memorandum of Understanding (MoU), and twice to President Anastasiades on 15 and 21 March 2013.
When should the ECB or CBC threatened to have pulled the plug on Laiki, thereby forcing the government to sign the MoU? The chart tells us it should have been as early as February 2012 (Chart 5).
Theories abound about why the outgoing CBC governor, Panicos Demetriades, did not act sooner. Was he naïve, thinking the government would sign any day soon? Was he doing the government’s bidding and kicking the can down the road so that the next government would have to pick up the tab? Was he doing the bidding of big EU countries and waiting for all those European banks to get their money out of Cyprus?
We shall never know. But the result of that delay raised the cost of the bailout/bail-in by many billions of euros.

…as did mistakes by Cypriot professional services…
Before we get onto the role of the Europeans, we need to introduce mistakes made by the Cypriot professional services sector.
One of the key ways in which north Europeans justified to themselves the unprecedented haircut on depositors was perceptions about Cyprus as a money-laundering centre, something dating back to the days when concrete bags of cash arrived in the middle of the night from Milosevic’s Serbia.
I have been the first to point out that we do not have (why don’t we have?) a proper system for proper comparison of EU countries’ money laundering records and that Cyprus has probably been judged too harshly.
But a country that international media continue to describe inaccurately as a “tax haven” needs not only to have stronger legislation than others in place, it needs to be seen to enforce it.
Moreover, the clean companies should have been pushing for it. But were there any money laundering cases before the crisis? I cannot remember a single one.
Yet before the bail-in, a German video was doing the rounds showing a Cypriot professional boasting how he warned his client of an impending investigation. That professional should have been hung out to dry. Instead, he is probably still doing business.
Another mistake of the professional services sector was not to realise how deep Western feelings run about Russia.
I was brought up in NATO-member Britain. In the 1970s, we were led to expect that any time we could have four minutes’ notice of obliteration by a Russian nuclear bomb.
As citizens of a non-aligned member, Cypriots are perhaps unaware of how west Europeans (or like Chancellor Angela Merkel and the German finance minister, Wolfgang Schaeuble, both former East Germans) think about Russia.
The rest of Europe does plenty of business with Russia, but unlike Cyprus, it does not go around boasting about it.
Unfortunately, the bad press from the Milosevic days, and perhaps more importantly, the fact that no one was ever brought to book for it, has left a bad reputation for Cyprus ever since. Out of the dozens of media interviews I have done since the start of the crisis, I can remember only one or two when I have not been asked about money laundering. Mud sticks.

…which stoked the German election campaign…
The money-laundering reputation was fertile ground for a German Chancellor seeking re-election.
Germans were already fed up, quite understandably, with the three other bailouts of EU periphery countries which were largely funded by German taxes.
The inconclusive Italian elections on 24-25 February raised fears that Italy would soon be calling upon north European taxpayers for yet another bailout.
With an already fed-up population, it took only a single, questionably sourced report by the German Intelligence Service (BND) leaked to a pliant populist newspaper to light the flame of German indignation.
“We will not use German taxpayers’ money to protect the deposits of Russian black money in Cypriot banks”, crowed a key rival of Chancellor Merkel, Carl Schneider of the Social Democratic Party (SPD).
International media had a riot, using all kinds of false reports to bolster the case against Cyprus. “The number of Russians in Cyprus is 50,000” (the census says 10,000), “Russian deposits are EUR 30 bln” (when total non-resident deposits were only EUR 20 bln) and so on. Figures about foreign direct investment from the Russian Central Bank (which are completely different from CBC figures) were used as hard evidence of money-laundering.
No amount of my lone-ranger mythbusting on twitter could stop the tide.
But the flame lit by whoever commissioned the BND report served its political purpose very well: when Cypriots were “punished” with the unprecedented haircut on deposits, Merkel’s popularity soared. She won the election later that year.
Politics elsewhere also played a role. The new Dutch Eurogroup chief, Jeroen Dijsselbloem, had just bailed out one of his banks back home using a bail-in of bondholders (though not depositors). He did not like using taxpayers’ money to bail out banks (in principle I agree with him as long as everyone knows that these are the rules). As it turns out, he got to use Cyprus as a test case.
Another uncannily timed but flawed ECB report on the wealth of different eurozone countries, issued just before the formal decision on the Cyprus bailout in April, helped EU leaders justify what they had done to this little island.

The economic illiteracy of parliament
Another mistake that amplified the impact of the bailout/bail-in was parliament’s rejection of the first idea, namely a 6.75% haircut on all depositors in all banks and a 9.9% haircut on those over EUR 100,000.
While it might have been a bigger shock for the eurozone as a whole, it would certainly have been a milder one for Cyprus. We might even have been looking forward to economic growth this year.
But the parliamentarians (apart from ruling DISY), perhaps sensing that an example was being made of Cyprus because it was small, gave a resounding no.
At the time many Cypriots were proud of that decision. But as we now know, the alternative was considerably worse. Bank of Cyprus is now lumbered with a EUR 9 bln ELA debt that it may never be able to repay and which will limit the economy’s growth potential for possibly decades to come.

The naivete of the incoming government (and me)
One final mistake was made by the incoming government and, I confess, me too. Charmed by the visit of Chancellor Merkel in January, we all thought that Germany was going to give the pro-EU, NATO-friendly, incoming government the benefit of the doubt.
“Merkel is Anastasiades’ friend” we thought, so Germany would support a full bailout for Cyprus. We dismissed the Financial Times leak about haircuts as ridiculous.
Little did we know what the European Commission, the Eurogroup leaders, or whoever else you want to blame for the haircut idea, had in store for us.