The frustrating search for the cause of the Cypriot financial crisis

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By Dr. Jim Leontiades
Cyprus International Institute of Management

What caused the Cyprus financial crisis? There has been much speculation, some charges of blame, but little in the way of a satisfying, definitive assignment of responsibility. Those who expect such clarity are likely to be disappointed. Like most major events there is no single “cause”. No single person or group to be assigned sole responsibility. That may not be very satisfying, but it is nearer the truth. Below are some of the contributing elements:


 
Greek Bonds:
Prior to joining the Euro zone in 2001, the Greek government had to pay an interest rate which at times reached over 25% in order to borrow. Once it joined the Euro, things changed. The Greek government found it could borrow at a much lower rate (4-5%). Massive amounts of Greek bonds (rated as ‘zero risk’ by the European Central Bank) were issued by a government running massive deficits. The result was predictable. Credit dried up. Greece defaulted on its bonds. Holders of Greek bonds, including the Bank of Cyprus, suffered massive losses.
Lehman Brothers: The 2007 bankruptcy of the Lehman Brothers bank in New York sent shock waves through the financial world. Banks in other countries became more cautious. Credit for countries with weak finances such as Greece became more difficult.
Laiki Bank: When HSBC Bank sold its share in Laiki, control of the bank was purchased by the Greek Marfin Investment Bank and a Middle East investment fund. The new owners, through mismanagement and deals which are still being investigated, presided over a steady deterioration of the banks finances. The Cyprus government injected 1.8 billion euros of money borrowed from Russia in a vain effort to save the bank.
The European Central Bank: The ECB, ultimately responsible for the prudential management of the European banking system, extended credit to Laiki in the form of ELA (Extraordinary Liquidity Assistance) long after the bank should have been declared insolvent. ELA lending to Laiki eventually reached more than 9.5 billion Euros, over 50% of Cypriot GDP. Prudent banking practice would have required that this be terminated much earlier, saving the country many billions of euros of debt.
The Cyprus Central Bank: The Governors of the Cyprus Central Bank permitted the takeover of Laiki and presided over its massive accumulation of ELA debt and eventual bankruptcy. Panicos Demetriades, Governor at the time of the crisis, continued to support the supply of ELA to Laiki long after it should have been terminated and the bank declared insolvent.
The Cyprus Government: The year 2008 found the country with a relatively low national debt of 8.3 billion Euros (49% of GDP). Under the Christofias presidency, spending increased. The national debt almost doubled to 15.4 billion Euros. International rating agencies downgraded Cypriot creditworthiness. The independent Commission of Inquiry into the Financial Crisis placed primary political responsibility for the financial crisis on the Cypriot government during this period as well as the parties supporting it.
The Size of the Cypriot Banking System: The rapid growth of the Cypriot banking system was responsible for much of the pre 2012 prosperity on the island. However, the very size of the system, over five times the size of the island’s GDP, also meant that the funds required to provide support to a major bank moving toward insolvency could well be beyond the government’s ability. This turned out to be the case. (But note that the Luxembourg Banking system is much larger)
Money Laundering: Prior to 2013, few major banks were accused of money laundering. The accusations on this score against Cyprus, particularly in the German press, contributed to the harsh treatment Cypriot banks received in the Euro group assistance agreement of March 2013. Since this period, a wide number of European and American banks, e.g., Deutsche Bank, Barclays, Credit Suisse, HSBC, RBS, Goldman Sachs, Citibank, etc., have been found guilty of numerous illegalities including money laundering , tax evasion, fixing interest rates and handling drug money.
Euro Group Experiments and Bungling: In March of 2013, a bankrupt Cyprus turned to the Euro group for assistance. It received 10 billion Euros for certain needs which specifically excluded the use of such funds for refinancing the two troubled Cypriot banks. The haircut on bank deposits followed. The deal with the Euro group also included a number of much needed reforms to be implemented by the Troika.
The legality of the haircut experiment and the treatment of the Bank of Cyprus, its investors, as well as those of Laiki is still being questioned. However, there is little doubt that the unexpected and unprecedented expropriation of depositor’s money triggered a crisis in the Cypriot banking system as well as a damage to confidence in banks and banking in Cyprus and beyond. The island’s economy is slowly recovering.
In years to come analysts reviewing this period may well conclude that, although the patient recovered, the Euro group prescription of March 2013 was flawed in its economics and of doubtful legality.
Who is responsible for the Cyprus financial crisis? There is no shortage of candidates.