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Banks, Governments and Cyprus

posted by Anna Gelpern

A key point is at risk of getting buried in all the din surrounding Cyprus's deposit levy (apparently poised for parliamentary defeat). To me it comes through most clearly in the latest from the tornado-chasing (or front-running?) duo, Lee Buchheit and Mitu Gulati. 

One message of the Cyprus program is that bank liabilities must not become sovereign liabilities. It is consistent with Europe's imperative of breaking the bank-government cycle. The approach implies that banks' creditors may suffer while the sovereign's creditors are spared--even in a systemic crisis. This might happen on purely ideological grounds (No Bailouts, Ever), or when the sovereign has no money/no appetite to nationalize the banks, or when government debt is a huge portion of the banking sector's assets. Proponents of the levy believe that going after the government's creditors here is both pointless and bad for incentives. Best to keep the banks separate, and to attack the problem at the source.

My hunch is that this entire line of argument is farcical, because banks and governments are, and always have been, joined at the hip. The purported separation is an accounting cover-up.  The fact that the separation is accomplished by means of mega-financial repression underlines the irony.

Now to Buchheit-Gulati. Their preferred method for dealing with Cyprus effectively recognizes that both sides of a private bank's balance sheet are public policy constructs. On the liability side, they would extend deposits over EUR100,000 into five and ten-year CDs; on the asset side, they would restructure the domestic government debt. Presto, you have filled more than half of the program financing gap without touching insured depositors.

The Buchheit-Gulati way only makes sense when you think of banks and governments as communicating vessels, and work both sides of the bank balance sheet simultaneously, guided by a clear hierarchy of distribution policy priorities. They propose to suspend maturity transformation and redeploy fiscal resources in exchange for protecting small depositors. The current plan creates the illusion of only working the liability side of the balance sheet--Sending a Message to Debt. As Buchheit and Gulati point out, it gets you little when the rump deposits run for the hills and the government must step in anyway. Now that will surely do wonders for the government bonds on the asset side of the balance sheet. Cycle broken, crisis solved.

***

For more on Cyprus, see Adam's coverage here, Jacob Kirkegaard here, Nicolas Veron here, Rob Kahn here, and FTAlphaville here. UPDATE: Felix Salmon just posted an excellent post-vote post-mortem here.

Comments

Growing German power in Europe and the divisiveness and resentment that it generates have become one of the main topics in European politics. Curtailing German power was in many ways a founding principle for Europe. Alas, recent events in Cyprus and the bailout deal, lead by Germany, involving haircuts for Cypriot depositors as a form of a bail-in (the original idea for a bail-in did not involved depositors), are calling the balancing of German power and European interests into question.

The traditional balancing mechanisms are no longer in place. Britain is not a member of the Euro and thus sidelined. Italy and Spain are in financial distress and dealing with austerity measures. France, traditionally the intellectual leader of Europe, under Francois Hollande is no longer playing an equal role to Germany. Michel Barnier, EU internal market commissioner, does not counterbalance German influence in the way Jean-Claude Trichet did during his tenure at the ECB.

This is a dangerous situation for Europe and calls into questions basic European ideals and principles. Germany’s financing of Europe in return for making and enforcing the rules can lead to a dangerous self-fulfilling prophecy and may create a downward spiral in European politics and policy-making. The long-term success of the European Union requires a balancing of interests. Germany has to find a way to support Europe without overreaching.

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