Just Let the Troubled Banks in Cyprus Fail

Photographer | Collection | Getty Images

The real shame about the mess in Cyprus is that it's all so unnecessary.

All the complicated proposals aimed at restoring the solvency of Cyprus' insolvent banks, all the confusing false flag plans, all the Great Game geopolitics surrounding the natural gas resources, the threat to the unity of the European Union, and the unsettling of the Cypriot people.

It's all unnecessary. There's a much better, and simpler, alternative that has been available right from the start.

Let the failing banks fail.

Only The Wall Street Journal's editorial board seems to understand this:

Cyprus's two biggest banks, Laiki and the Bank of Cyprus, are deeply insolvent. While the EU, the IMF and Cyprus could spend the weekend trying to negotiate a deal to inject billions into the banks, the time would be better spent arranging for their bankruptcy.

Here's how it could work: Shareholders, along with senior and subordinated debt holders, would be wiped out. Deposits up to €100,000 that are insured would be protected. Larger depositors would take a haircut in the range of 40 percent—somewhat more for Laiki depositors, somewhat less for account holders at Bank of Cyprus, reflecting the extent of the losses and the capital needs at the two banks.

In exchange for their losses, these depositors would get all the new equity; they would become the proud owners of two newly well-capitalized banks. No public funds would be needed to save the banks, and both creditor seniority and the rule of law would be respected. Cyprus would be able to take its banking problem off its books at a stroke, and the banks could reopen on schedule Tuesday with full access to the ECB's emergency liquidity assistance, if needed to meet any withdrawal demands.

This would both avoid the need for the German government to approve something its people so obviously do not: bailing out another Mediterranean country. It would avoid the moral hazard of a bailout. It would avoid defaulting on deposit insurance promises. And it avoids asking Cyprus to sell or mortgage its valuable energy assets.

One of the biggest problems with an across-the-board levy on deposits is that the penalty on savers would be divorced from the level of insolvency of their bank. Careful savers who put money in one of Cyprus' healthier (relatively speaking) banks would suffer with those who carelessly kept their money in Laiki. This was its own form of moral hazard—discouraging public monitoring of bank risk.

The unlearned lesson of Lehman remains badly unlearned. The problem wasn't that Lehman failed—it was that the government was never able to send a consistent message about its approach to troubled financial firms. Bear was rescued, Fannie and Freddie brought into something called a conservatorship, Lehman bankrupt, and AIG bailed out. No wonder chaos broke out.

This is what's at risk in Cyprus. There seem to be no agreed-upon rules, no official process, nothing that can be counted upon.

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