Tags: Cyprus | AEI | bank | Eisenbeis

AEI Experts Struggle with Cyprus Crisis

Wednesday, 24 Apr 2013 02:25 PM

By Robert Feinberg

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On Tuesday, the American Enterprise Institute (AEI) held an event, titled “Lessons from the banking fiasco in Cyprus,” to discuss this episode in the ongoing global financial crisis that is still unfolding. Perhaps it is premature to distill clear lessons, and it might be more accurate to say that the panel produced insights that will be better understood, as former Sen. Alfonse D’Amato, R-N.Y., is fond of saying, “in the fullness of time.”

In his introduction, AEI’s Alex Pollock listed significant losses, asset haircuts, insolvencies of governments and a strong desire for riskless deposits as ingredients of the crisis. He put forward one of the first lessons learned — that businesses funded by deposits are inherently risky. I would add, and for some reason, it appears to be necessary to do so, that banking is one of the riskiest businesses, because it is not only funded by deposits, but the largest banks are funded by very short-term deposits, such as overnight repos, that fund long-term assets of, to put it somewhat delicately, variable and somewhat indeterminate quality. Pollock noted that the International Monetary Fund (IMF) has found that there have been 170 banking crises since 1970.

The panelists were Robert Eisenbeis, former high-ranking researcher at the FDIC and Federal Reserve, now with Cumberland Advisors; Doug Elliott, a fellow in economic studies at the Brookings Institution; Bert Ely, a banking economist; and Desmond Lachman and John Makin, two banking economists who have consulted for the IMF and are now with AEI.

Eisenbeis’ presentation was, in my judgment, by far the most useful, and if readers were to select one for viewing, this would be the one to pick. He began by laying out some facts about Cyprus, which joined the European Union in 2004 and the euro in 2008. Its economy is 81 percent based on services, principally financial services and tourism, so, as Eisenbeis put it, “They don’t make a lot in Cyprus.” Banking assets in Cyprus are seven times the gross domestic product (GDP), and the GDP as compared with the rest of the European Union barely shows up on the chart at 0.2 percent. Cyprus’ GDP is smaller than that of Shreveport, La., and half the size of Rochester, N.Y.

The original figure the Cypriots put on the extent of required assistance was 1.8 billion euros, and it escalated in steps to 23 billion euros, so Eisenbeis suggested that one of the lessons might be to multiply initial estimates in such circumstances by 10.

He observed that the ensuing negotiations centered on who would pay. The idea was floated that a 9.6 percent penalty would be imposed on uninsured deposits and a tax would be placed on insured deposits. Ultimately the penalty was only imposed on deposits exceeding 100,000 euros, and eight different amendments exempted various categories of deposits, such as those of the Church of Cyprus. The target of the penalty on uninsured deposits was Russian oligarchs and money launderers.

Eisenbeis cited a Reuters article to the effect that Russian depositors were able to withdraw a lot of their money through the extensive branch network of Cypriot banks, and Makin agreed, but Elliott express doubt that much of the money actually left. However, a lesson of the episode is that depositors tend to lose sight of who the intended target might be and to resolve to move deposits to Switzerland or Germany at the first sign of trouble, especially in places like Malta, Italy, Spain and Greece.

Eisenbeis concluded by recalling that the United States once had a plethora of state deposit insurance programs, and they all wound up being bailed out by the federal government. He identified the administration of deposit insurance as the main policy issue in the Cyprus debate, and he called for regulators to implement “prompt corrective action” and leverage ratios to contain risk.

Elliott asked how the EU policymakers managed to screw up the Cyprus crisis. Among the contributing factors he listed were complacency arising from the declaration that the European Central Bank would do “whatever it takes” to support the economy, leading to a willingness to accept greater risk; the sensitivity of the fall elections in Germany, making Chancellor Angela Merkel skittish about doing anything that might be interpreted as a bailout of bankers; and the fact that all of the participants in the planning saw the maintenance of stability in the eurozone as their third priority.

He predicted that money will flee faster in the next crisis, and he called for action to establish a deposit insurance system for the eurozone. However, he estimated the probability that the European Union/eurozone would manage to muddle through at 80 percent, probably the most optimistic on the panel.

Among the remaining panelists, Makin warned that Cyprus could be the proverbial canary and that corporate treasurers would be more nervous and quicker to flee to rolling over treasuries rather than maintaining cash deposits. This increases the risk that one day they would run from banks, causing the money supply to collapse, a circumstance he said would overwhelm the ability of the Federal Reserve to respond.

Ely discussed concerns raised by Pimco regarding the idiosyncratic nature of banking in Cyprus, which relies excessively on asset-based lending and cross pledging of collateral and is attended by deficiencies in the recognition of loan losses.

However, Ely seems to have a blind spot when it comes to recognizing the prevalence of many of these same features in the United States. He asserted, “Good banking can be practiced anywhere,” but I would retort that the U.S. banking crisis shows that this is also true of bad banking.

When he proclaimed, “Banking should exist to serve the economy, not be the economy,” it was evident that he did not appreciate the irony of this statement from the standpoint of U.S. practice.

Lachman faulted Cyprus for joining the euro in the first place and for allowing unregulated banks to grow so large, and he called the attempt to tax smaller depositors “a monumental error.”

Finally, the wild card may be that a huge deposit of natural gas has been found offshore of Cyprus, one that might improve the country’s long-term prospects. Here, again, there might be a parallel to both the European Union and the United States. Many factors, including international political considerations, will affect the how and who of the development of this resource, an issue that will be the subject of a future article.

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