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Cyprus Bailout: What Happened to Absolute Priority?

posted by Adam Levitin

Cyprus seems to be the next European domino to fall to bailoutitis.  Here's the situation as I understand it. Cyprus has unmanageable government debt, not least because of the liabilities that stem from supporting the insolvent banking sector. The EU will put in money to pay off Cyprus's bondholders, but only if there is a copay from Cypriot taxpayers.  Cyprus seems to have decided that the best way to do this co-pay is a (supposedly) one-time tax on all bank deposits. The tax is slightly progressive, with a higher rate on big Euro deposits.  

There is, of course, always the issue of whether there should be a bailout. But putting that aside, the problem with the Cypriot bailout, as I see it, is that it is a bail-in that does not comply with absolute priority because being done through the tax system, rather than through an insolvency proceeding. The problem isn't that Cypriot depositors have to make a co-pay, but that the co-pay costs are not being divvied up among Cypriot depositors and the other creditors and equityholders of Cypriot banks either per absolute priority or ratably. For all of the complaints about absolute priority violations with GM and Chrysler's bankruptcies, the Cypriot situation looks much worse. 

If the EU is going to act as insurer for Cypriot bonds, I can't say that its EU is wrong to demand a copay from the Cypriots. In other instances, the co-pay has been austerity/privatization demands (and those seem to exist for Cyprus as well). It's not so strange to think that the co-pay will come in lump cash payment.  The EU seems to think it quite clever to do this by taxing Cypriot depositors. It seems that the thinking is that at least part of that cost will be borne by wealthy (read criminal) Russians who have been using the Cypriot banking system for fear of expropriation by their own government, so ha-ha-ha.  The laugh is on you, vory, seems to be the German thinking. (Who knew that bank deposits were safer in Russia than in Cyprus?)

If the concern is that the state isn't able to collect taxes effectively in an on-going fashion (certainly a problem in Greece), then better to grab the money from the easy target (the bank accounts) now. There are equity issues with the structure of the tax (it's not especially progressive), and with the fact that it end-runs Cyprus's 100,000 Euro deposit insurance guarantee, but Cypriots are going to be making a co-pay whether in a one-time (very salient) cash payment or over time. Still, I wonder whether it is wise to do this all in one fell swoop or whether it is better to stretch out the pain. This is such a different approach than we've seen everywhere else since the financial crisis.  

The problem with the use of the tax on the bank depositors to ultimately bail out Cypriot banks is that it appears to completely disregard creditor priorities.  Imagine what would happen if the Cypriot government didn't get the bailout. It wouldn't be able to support the Cypriot banks. The banks would collapse, and depositors would take it on the chin...but so too would the banks' bondholders and equity owners.

I don't know the details of Cypriot bank insolvency law, but let's assume that as with most of the Western world, the depositors rank equal to or perhaps senior to the banks' other creditors (both long bonds and their short-term repo creditors, etc.). If so, then what we're seeing in Cyprus is a huge deviation from absolute priority by doing the bail-in using the tax system, rather than as an insolvency move.  (The EU seems to have taken a page out of the Affordable Care Act playbook.) 

Formally there is no reason that taxation ever has to track absolute priority. But when taxation is simply the means of implementing a bail-in, it is not clear to me why taxation should not have to follow insolvency rules like absolute priority or at least a strict type of relative priority. The problem here isn't that the Cypriot bank depositors are being made to fund a co-pay for an EU bailout. Instead, the problem is that the other creditors and equityholders of the Cypriot banks aren't being forced to share the cost of the co-pay at least ratably, if not getting wiped out per absolute priority.

Still, having made a fuss about all this, it's worth stepping back and thinking about how absolute priority has been applied in other EU bailouts. The absolute priority problem with Cyprus is apparent because there is an immediate cash payment. But the problem exists too with austerity programs. Those programs spread the costs throughout the populace, in order to enable the governments to bail out the banks. Assuming that most of the costs of austerity are borne by depositors, rather than by other (financial and frequently foreign) creditors of the banks, then there is an absolute priority problem.  While the depositors are not impaired qua depositors, they are impaired when one accounts for the costs of austerity.  The depositors should not have this impairment without other bank creditors (long bonds, short-term repo, swaps, etc.) also being impaired if absolute priority is to be honored in anything but the most narrow technical sense. But as we learned with GM and Chrysler, bankruptcy borderlines count, and concessions made or gained outside of bankruptcy don't count anymore when evaluating absolute priority, even if they were a central part of Justice Douglas' thinking in the 1939 Los Angeles Lumber decision that established the absolute priority rule as the law of the land. 

Here's an overview of the Cypriot deposit insurance program.

[Update 3.18.13:  It now appears that at least the junior bondholders of Cyprus's banks will be wiped out under the EU bail-in proposal. Cyprus' banks don't seem to have much non-deposit debt, however. I haven't seen anything about senior bondholders (if they exist). I would imagine that to the extent they do, they are senior only to the junior bondholders, not to the depositors, unless Cyprus allows some sort of secured bank debt, sort of like covered bonds. If they are only senior to the juniors, not to the depositors, absolute priority would demand that the seniors take a hit too.]

Comments

Depositors would not "take it on the chin" if the banks failed because of EU deposit insurance for up to 100k. This leaves them worse off to the tune of 6.75%. It's just outright theft

Such diversions from standard priority rules will make large depositors wary of this risk for the future, which will steer them to perceived safer places for their money. Professional money launderers will be able to get out in time; ordinary folks, large depositors or small, will be left holding the bag.

What happened to absolute priority? It vanished back in 2008 don't you know?

Who gained by the moneylaundering other than the depositors themselves? The shareholders ...

Who should have policed the bank policies? The shareholders....

who received bonus interest rates by "looking the other way" at the bloated balance sheets?
The Bondholders....

If these parties escape the pain--they will not in future pretend to be responsible for their due diligence as investors. The burden will fall completely upon govt regulators to police the bank management---the govt will effectively be insuring high yield investments. The managements will see that they can take risks--investors will see they can take economic gains from even the worst behavior and the entire global financial structure will be a cross between a "den of thieves" and a pirates' fleet.

Other than the biggest banks, there aren't that many banks that have a significant amount of long-term bonds outstanding. That's because long-term bonds are much more expensive way of financing a bank's loans than deposits, which are either insured or shorter term financing, and thus generally have lower interest rates. For example, hardly any US banks outside of the top ten issue long term bonds.

For a related comparison of the Cyprus terms to chapter 11, see

http://thenecessaryandproperblog.blogspot.com/2013/03/chapter-11-comes-to-cyprus-depositors.html

Depositors are considered pari to SNR bondholders,implicitly, in the Eurozone. Precedent has not yet been set that SNR bonds are subordinate to depositors. I believe there was a significant amount of discussion around this topic for the insolvent Irish Banks.

Shareholders control the corporation? Hah! In the typical, publicly traded corporation, the shareholders have about as much influence as spitting on the railroad tracks has on a fast freight, except for a few institutional players that are in a wholly incestuous relationship with management and would never stop a con they are an integral part of.

I think the government as well as the banks are to blame for this problem. The solutions proposed now pose a risk to the Euro and other banks.Instead of taking the depositors hard earned savings and creating further problems they should provide what could be a workable solution.

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