Why the Cyprus Solution Will Hurt Market Stability

Cypriot protesters hold signs denouncing the EU bailout of Cyprus.
Michelle Caruso-Cabrera | CNBC
Cypriot protesters hold signs denouncing the EU bailout of Cyprus.

What appears to be the final resolution of the crisis in Cyprus may not be perfect but it does not stray that far from the approach advocated here and on The Wall Street Journal's editorial page last week.

But a good resolution of the Cyprus crisis may not be enough to undo the damage from interventions that are not based on clearly stated diagnoses or predictable frameworks for government actions.

The lesson that policymakers should have learned in 2008 was that massive ad hoc responses with little public explanation undermine market confidence. Such interventions, developed through secret meetings, promote uncertainty and fear. If, as the gentleman once said, the only thing we have to fear is fear itself, this is the perfect recipe for producing that dangerous dish. (See this paper by John Taylor on how unpredictable intervention worsened the reaction to Lehman's collapse.)

The last-minute deal agreed by Cypriot and EU leaders will impose serious losses on the creditors of Laiki Bank, also known as the Cyprus Popular Bank. Some 4.2 billion euros in deposits of more than 100,000 euros will be placed in a "bad bank," meaning they could be wiped out. Smaller deposits will be moved to the Bank of Cyprus, which will see its own deposits in excess of 100,000 euros frozen while the bank is restructured and recapitalized. A good portion of those deposits—it's not clear exactly how much—is likely to get converted into Bank of Cyprus equity as part of the recap.

Imposing losses on the creditors of failed banks—including uninsured depositors when the losses are extensive enough to wipe out bondholders—should have been the first reaction of policymakers. Instead, they sought to spread the burden of propping up Laiki and the Bank of Cyprus by imposing a tax on accounts of all depositors, including those in healthier banks.

As economic historian Anna Schwartz explained five years ago: "Firms that made wrong decisions should fail."

"You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich," Schwartz told The Wall Street Journal.

It's not clear why Laiki has to be wiped out. Perhaps its losses are worse than they have let on. But credible sources I spoke to thought the bail-in recapitalization should have been able to work for Laiki.

It's also unclear why the Bank of Cyprus' bondholders have not yet been wiped out. Depositors should sit on the top of the capital structure. If some deposits are being converted to equity, this should only be a last resort after the wipeout of other creditors.

I suspect the answer to these questions is that both banks were debtors to the European Central Bank. The ECB is unwilling to take losses on its support for banks, so it has arranged a scheme to wipe out Laiki while moving Laiki's ECB debt to the Bank of Cyprus. This isn't necessarily a terrible policy—but it is terrible that we're left speculating rather than being given direct answers by the authorities involved.

It's striking that this level of public dithering can be combined with the extreme lack of transparency. One would think that nothing kept this secretive could possibly look so publicly foolish at the same time. Once again the Eurocrats have outperformed expectations.

It will hardly be surprising if the fallout from this is far more traumatic to markets than the Eurocrats expect. They've revealed that they're still making this stuff up as they go along, that there is no way of predicting (much less quantifying) the risks of unprecedented policy moves being undertaken for unheralded interests. Not exactly the stuff that builds confidence, stability, and trust in a financial system.

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