March 19, 2013

Why You and Your Clients Should Care About the Cyprus Bailout

Just when I’d hoped things couldn’t get any more bizarre, my weird-stuff-o-meter went off the scale yesterday morning (March 18, 2013) when I read the lead story on AdvisorOne titled “El-Erian on Cyprus: ‘Europe Lit Two Sticks of Dynamite.’” It seems that as a condition for a rescue loan to the government of Cyprus, the European Central Bank Executive Board has required that Cyprus raise 5.8 billion euros ($7.6 billion) from bank depositors in Cypriot banks. According to Bloomberg, the original idea agreed to by both the ECB and the Cyprus government was a “levy” (that just sounds so much nicer than “tax,” doesn’t it?) of 6.75% on all deposits up to 100,000 euros and 9.9% above. These euros would simply be seized right out of bank deposit accounts.

This theft, I mean windfall, would bring the required bailout down to 10 billion euros ($13 billion) from 15.8 billion euros ($20.6 billion). To put all this into perspective, the Cypriot economy generates goods and services worth about 18 billion euros ($23.4 billion) a year.

According to BusinessWeek.com, this bank tax was considered a better alternative to defaulting on Cypriot treasury bonds, forcing the bondholders to eat the 5.8 billion euro loss. I suppose the thinking was that default would make it nearly impossible for Cyprus to borrow more money, which to politicians everywhere seems to be just crazy talk. BusinessWeek.com quoted Marshall Gittler, head of global foreign-exchange strategy at Limassol, Cyprus-based IronFX, explaining the choice this way: “Obviously, people would have preferred to pay nothing, but it’s a better deal than it could have been. It’s unusual to ask depositors to take a hit, but if they hadn’t then the hit would have fallen uniquely on Cypriot taxpayers, so in a sense it’s fairer.”

Ah, yes, the old “fairness” doctrine. As reports come in of long lines of Cypriots queuing up at ATMs to take their money out of Cypriot banks, it’s a little hard to believe that the “depositors” aren’t at the same time also “taxpayers." So it’s not clear to me who was spared here. But, of course, the bigger issue is that if the European Central Bankers can rationalize that seizing bank deposits is an acceptable solution to government overspending, how long will it be before other politicians around the globe come to similar conclusions? 

I suppose it’s possible that European bankers haven’t seen “It’s a Wonderful Life,” but I still believe they understand that banking systems everywhere are dependent on people’s trust in them. Let’s take the U.S. banking system as an example. According to Bloomberg, at the end of 2012, the average loan-to-deposit ratio for the top eight U.S. commercial banks was 84%. That means our top banks had leant out 84 cents for every dollar they took in deposits. And 2012 was a good year: in 2011, the loan-to-deposits ration was 87%, and in 2007, it was 101%.

Still, if U.S. banks have, say 80% of their deposits lent out, that means they only have 20% available for their current depositors. You see where this is going, right? 

If, say, the U.S. Congress even started to hint that U.S. bank deposits were just too attractive to leave untaxed, a lot of depositors might get spooked about the safety of their banks, and rush to take their savings out. If it were more than 20% of depositors, there wouldn’t be enough money to pay them off. And, hearing that, more depositors would get spooked. Then there wouldn’t be enough money to pay them all off—anywhere. Could this happen? It did in 1929. 

I’m sure (well, almost sure) that the European bankers have thought of all this, and won’t let things get out of hand—this time. But as markets around the world are indicating, the world changed over the weekend.

The seizure of bank deposits is no longer the purview of Communist regimes and tin-pot dictators. The unthinkable is now a potential solution for cash-strapped governments (and today, what government isn’t?). 

From now on, prudent financial advisors will have to consider this possibility as they advise their clients where to park their rainy-day funds and extend the concept of diversification to short-term vehicles as well. 

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