The European Debt Crisis and the Euro - Page 105

First they came for the deposits…

This won’t be popular.

But it’s an important alternative to the “it’s expropriation” view on Cyprus.

While the decision to force a bank levy on depositors creates an important precedent, it also represents something much more complex than pure confiscation or forfeiture. It’s certainly not expropriation in the communist or command economy sense, that’s for sure.

In fact, I’d argue that what it really represents is the inevitable shift away from a debt funded economy to an equity funded one.

That’s not to say the shift has been managed fairly or logically. I’m with Willem Buiter on the point that it would have been better if small island depositors had been spared. But I’m also with him on the point that this is ultimately a step in the right direction.

It all comes down to the need to capitalise failing banks with equity, and to get creditors taking responsibility for their bad investments.

I’m going to write now in general terms, and not about Cyprus specifically.

Indeed, ever since I met with Anat Admati, co-author of the Bankers’ New Clothes — an ardent advocate of more equity funding for banks — I can’t get the following point out of my head: bank creditors are far too nice/presumptuous a breed of creditor.

What that means is that the funds they provide are information insensitive — mostly because they are insured or presumed to be amongst the safest creditor claims out there on account of bank runs being so very undesirable.

The problem, of course, is that the presumption factor obscures the “information discovery” process, meaning that by the time negative information leaks into the depositor base, it usually causes a flash-crash style over-reaction. That is, when it leaks it over-leaks, causing panic, leading to depositors making irrational choices which often cause unjust bank runs.

As Admati noted to me, it’s not that information insensitive funds are intrinsically bad. Insuring deposits is and continues to be the best way to stabilise the system, and mitigate runs which might otherwise be started due to irrational or base-less over reactions. But at the same time, insurance and guarantees breed bad banking behaviour and encourage depositors and creditors to poorly evaluate risk. Banks understandably exploit the under-assessment, taking risks that they might otherwise not take.

There is accordingly a lot of logic in trying to make depositor funds more information sensitive, so that banks can be held to account by those who have some “skin in the game”.

Now back to Cyprus. What’s happening there in many ways is a path towards greater information sensitivity. Unfortunately, it’s not been fairly implemented because the levy in its current form penalises insured depositors as greatly if not more greatly than other uninsured creditors.

Forcing depositors to become holders of already compromised equity post facto thus seems particularly harsh. Remember, the reason this is being forced upon them is because Cypriot banks cannot raise fresh loss-absorbing equity any other way.

What does this really say about the state of the banks in the longer run?

Equity funding is available and “cheap” to the right businesses and projects. If it is not forthcoming, it suggests your business is most likely an unprofitable and pointless dinosaur unlikely to pay dividends in the future. This makes equity a particularly important health gauge in the age of zombie credit availability, which has the habit of sustaining unprofitable ventures for far too long. Equity, after all, is the most information sensitive funding of all. (Small surprise that the corporate trend the world over — apart from in the innovative technology sector — is currently one of de-equitisation.)

What the equity market is telling us, therefore, is that these banks are unlikely to recover unless a major restructuring takes place first. And here lies the irony of using depositors to bail-in the banks: much needed restructuring is in many ways avoided.

This means that if it hasn’t already, it’s just a matter of time before all the equity given to depositors is wiped away anyway.

On top of everything, the levy also turns the whole point of insured deposits on its head. Why should depositors be wiped before other pari passu senior debt holders, or even junior ones?

Remember, money (deposits) in many ways represent your stake in the national equity pot. That’s why deposits can be insured. Your stake in the economy never changes. What changes is the size of the pie your stake (share) represents.

What’s different in Cyprus’ case, of course, is that the size of the pie is being dictated by external forces. So it’s not the national insurance which has necessarily failed in this case, it’s that Cyprus’ external creditors have started demanding more of an already diminishing pie to compensate for broken promises. So what a depositor thought he had, he has less of. Nationalisation or no nationalisation, it’s the size of the pie that has been reduced either way.

Yet because the move is a blanket move, it’s unlikely to lead to better behaviours. There is, after all, no differentiation between healthy and less healthy banks. Information sensitivity may have risen, but not in the sort of way that encourages depositors to make smarter choices domestically. At best, they’ve only been encouraged to divert money abroad.

Meanwhile, the problem of too little equity remains.

Think of it this way. If I can persuade people to keep giving me money to look after (rather than to risk), I can continue to make poor loans — and I won’t be found out until the funding is either taken away from me completely via a depositor run (in which case I won’t have enough to give back), the bad loans are so bad I can’t even afford to pay the interest I owe (less of a problem in the zero yield environment), or last and not least the loans mature and I suffer principal loss.

The last situation can be easily masked if I can persuade new depositors to fund that loss unwittingly. Especially if I delay the realisation of those losses for as long as possible.

And that’s really what has been happening post-crisis all over the place. All deposits retained in zombie banks (rather than nationalised ones where the equity gap has been funded by government instead ) were already in reality funding such implicit losses unwittingly.

In other words, the moment you gave deposits to a bank whose loans were failing or were set to fail, you were effectively providing loss absorbing equity anyway.

The Cyprus move, in many ways, makes overt what was already the case. It just protects some parties unfairly from the process.

The good news is that depositors should now realise that when governments can’t afford to take the hit on their behalf (by nationalising the banks) or support positive deposit returns indefinitely (like the US can by giving away free national equity by means of paying IOER ), and fresh equity is not forthcoming, it’s depositors and creditors who end up bearing the risk of non-performing loans instead. Furthermore, given that banks have a tendency to delay loss realisation, that equity losses are already being weathered somewhere in the creditor base.

In short, there is already an implicit negative interest rate associated with lending to the banks. We just don’t know it.