- Money Morning Australia

Why the Cyprus Bailout Could Set Banking Back 300 Years


Written on 20 March 2013 by Martin Hutchinson

Why the Cyprus Bailout Could Set Banking Back 300 Years

Even by the standards of the EU bureaucracy, raiding the private deposits of Cyprus’ banks is spectacularly foolish.

For a measly €5.8 billion, the EU has now put the entire Eurozone on edge – not to mention the entire global economy.

It revolves around something as simple as trust. And as a former banker, I can tell you that there’s no substitute for the belief that your deposits are safe and sound.

It’s a thin line, and once it’s been crossed it’s nearly impossible to repair.

Now savers in Spain, Italy and elsewhere in the Eurozone are left to wonder about the safety of their own accounts.

Here’s why savers everywhere should be concerned…

The Problem with the Cyprus ‘Bailout’

Like Ireland and Iceland, Cyprus has a banking sector that’s not only shaky but is far bigger than its overall economy, with deposits of around $90 billion, or five times its GDP.

Unlike most banking systems, more than half of those deposits are in large chunks of over €100,000, the limit of Cyprus’ deposit insurance. Indeed, about $20 billion of Cyprus’ deposits are held by the Russian mafia.

Since Cyprus’ president Nicos Anastasiades didn’t want to shut down the island’s attraction as a money haven and playground for the Russian jet-set, he agreed to a deposit tax of 6.7% on deposits up to €100,000 and 9.9% on deposits above €100,000, to satisfy the EU’s demand of 5.8 billion euros part of the bank bailout.

But like most schemes designed by politicians and EU bureaucrats, this one has huge flaws, including the fact it angered Russian president Vladimir Putin. Even at this level, with much of the money coming from Cyprus’ modestly well-off citizens , Putin described it as ‘unfair, unprofessional and dangerous.’

But the main flaw isn’t about Putin. It has to do with the idea of deposit insurance itself.

Under a separate scheme introduced by the EU after the 2008 financial crash, deposits under €100,000 are insured by the Cyprus government.

Of course, the ‘tax’ on deposits is a supposedly clever way to get around this without the Cyprus government itself defaulting. However, all this little trick does is call into question deposit insurance throughout the EU and, indeed, worldwide.

That’s why this tiny country, with a population of only 800,000 and $17 billion in GDP, has roiled the world markets – it attacked the central principle of deposit insurance.

After all, if governments can just seize deposits by means of a ‘tax’ then deposit insurance is worth absolutely zippo.

Meanwhile in Cyprus, there were a number of alternatives to breaking this underlying bond of trust. The banks have some bond debts outstanding, which certainly should have been written down before the deposits were attacked. In fact, the tax is an attempt to avoid this, and should be resisted on that ground alone.

Instead, because the large deposits are so big, you could raise the required €5.8 million simply by a 15% tax on large deposits – but that would make Putin REALLY angry (he personally may or may not have money in Cyprus, but lots of his friends do).

They could also write down Cypriot government bonds, but because the banking system is relatively so huge the write-off would have to be a big one. To get €5.8 billion it would take more than a 50% write-down.

In the big picture, Cyprus doesn’t matter much, unless EU incompetence and the recalcitrance of its own politicians makes it leave the euro altogether, in which case that currency unit yet again faces the prospect of break-up.

Who Can You Trust?

But in this case, the effect on global deposit insurance systems is much more important.

Deposit insurance was first invented in the United States during the Great Depression as a means to reassure savers about the solvency of banks, a third of which had just gone belly-up. It worked beautifully.

Americans trusted the federal government (at least, they did back then), so once deposit insurance was in place savers came to have complete trust in the banking system.

Unfortunately, that same trust had a very bad effect on the banking system itself.

From leverage ratios of $4-5 of assets to $1 of capital in the 1920s, banks leveraged themselves ad infinitum, having leverage ratios of $10-12 of debt to $1 of capital in the 1970s, and up to $30 of assets to $1 of capital in 2008.

Even today, after de-leveraging, J.P. Morgan Chase, in many ways the most solid of the big banks, had assets of $2,359 billion at the end of 2012 and tangible equity of only $146 billion – or a ratio of 16.2 to 1. As recently as 2010, JPM’s leverage was 19.3 to 1.

At those levels you can see the dangers that kind of leverage presents.

In fact, I counselled the National Bank of Croatia to this effect, when they were designing their deposit insurance system in 1996-97, advising them to have insurance covering only 90% of deposits. Unfortunately the politicians in the Croatian parliament overruled us, so Croatia now has the same damaging 100% insurance as everywhere else.

So the depositor today ends up with the worst of both worlds. He can’t rely on the banks not to go bust, given their current absurd levels of leverage (which are of course encouraged by Ben Bernanke’s money printing). On the other hand, now there’s a question of whether he can rely on deposit insurance either.

If these worries become really serious, it will be devastating for the world economy. Small savers will take their money out of banks and resort to household safes and a shotgun.

If savers no longer have a solid place in which to put their money, we will have undone the financial revolution of the last 300 years, and returned to a world in which Samuel Pepys didn’t trust the local goldsmith, so buried most of his wealth in the back garden. Needless to say, that won’t do much for small business – the entire flow of finance will seize up altogether.

The solution is to do away with deposit insurance, forcing banks that want to attract depositors to hold $1 of capital for every $4-5 of assets, at most.

Eliminating Ben Bernanke and going back to a gold standard will probably be necessary too – even though that’s not likely to happen anytime soon.

But if politicians continue behaving as badly as those who designed the Cyprus bailout, the gold standard will be the only economically viable alternative.

With this ‘bailout’ all the EU has done is open up a Pandora’s Box.

Martin Hutchinson
Contributing Editor, Money Morning

Join Money Morning on Google+

From the Archives…

Can This Indicator Predict The Dow Jones Next Move?
16-03-2013 – Kris Sayce

Seven Situations to Watch in the Pacific Currency War
15-03-2013 – Dan Denning

Stock Market Warning: Next Week Could be a Blood Bath
14-03-2013 – Murray Dawes

REVEALED: One Opportunity to Escape Your Mortgage
13-03-2013 – Nick Hubble

UK Property: How You Can Buy a House For Less Than 250 Grand
12-03-2013 – Dr. Alex Cowie



Already a subscriber to Money Morning... or simply, just like what you're reading? Then show your support and spread the word...
Share this post on...
Share

Leave a Comment

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.

If you would prefer to email the editor, you can do so by sending an email to moneymorning@moneymorning.com.au




How Money Morning Can Help You Can Become a Smarter, Better, Investor


Privacy Statement
We will collect and handle your personal information in accordance with our Privacy Policy.
You can cancel your subscription at any time

Diggers and Drillers

A 3-Point Plan to Re-Engage with the Aussie Mining Boom


This new video reveals a way for Aussie share investors like you to RE-ENGAGE with the next phase of the mining boom…while valuations are still dirt-cheap…


The plan centres round three specific stocks.


To find out what they are, click here.

Australian Small-Cap Investigator

The Australian wildcatter
exploring oil's 'final frontier'


The US Geological Survey says this area contains up to 71 billion barrels of oil.

Only a few explorers have secured licences to drill.

One of them is a daring little Aussie firm that begins drilling 'in early 2014'.

According to small-cap analysts Tim Dohrmann it's impossible to speculate just how high this one could go. Find out why here.

World War D

Couldn’t make it to our
‘War Summit’?


Don’t sweat it. Click here for the next best thing…


World War D was the most important meeting of minds of the decade so far. What came out of it will almost certainly force you to reshape your investment plan for the rest of the decade. There's no way to go back in time and get inside the Savoy Ballroom of the Grand Hyatt.

But you can do the next best thing…
to find out what it is, click here.

  • ^NDX3534.532+1.446 - +0.04%
  • ^FTSE6625.25+41.08 - +0.62%
  • ^AORD5444.800+32.200 - +0.59%
  • ^AXJO5454.200+33.900 - +0.63%
  • AUDUSD=X0.933
  • USDJPY=X102.445

Graphic Ad 1 – Blue Chip Stocks Report


Revolutionary Tech Investor

This report is about TECH MOON-SHOTS


Four of them, to be precise.


It's an early-days project. But one biotech aiming for the cancer moon-shot is already up - get this - 497.14% since tipped.


For four more tech moon-shots, click here.

Gowdie Family Wealth

WARNING:
The worst mistake you can make when handing wealth on to your kids


This brand new investor briefing shows you what your family’s in for if you don’t take care to leave your wealth to them in exactly the right way.


And it shows you precisely how to prevent infighting, recklessness and misunderstanding over money.


Read it here.

The Money For Life Letter

Holden. Toyota. Qantas. BUST


Do you really expect the share market to boom in times like these? That's why Nick Hubble says the best thing you can do right now is invest for safety and income.


This brand new video shows you how you can get predictable, reliable and rock solid cash flow no matter what happens in the wider economy.


You could lock in up to $20,000 a year - and that's just the start. See how here.



Sound Money. Sound Investments. [bullish prediction]

Greg Canavan's first bullish prediction in four years


Greg Canavan
doesn't make forecasts like this often.


When he does, it's because he’s found something that could make you money for years to come.


Read more here.

Is the Australian Housing Boom Really Back?

The Denning Report

2014 Predicted


Dan Denning accurately forecast 2013's flight from
bonds to stocks, the commodities crash and the
Aussie dollar top…to the exact week


In this brand new forecast report, he shares his
three critical predictions for 2014…

More Recommended Reading Below...

The Pursuit of Happiness & The Daily Reckoning

  • The Pursuit of Happiness
  • The Daily Reckoning Australia

Done properly, a retirement business can not only help fill a retiree’s time and replace their work [Read More...]

Free speech is no longer really a right at all. Governments, vested interests, and lobby groups are [Read More...]

Australian house prices are going to remain high. Perhaps finally, when the last baby boomer retires [Read More...]

Make sure that the changes you make to your financial plan are from a credible source. Otherwise the [Read More...]

It was day two of the World War D conference, and the final session was starting. We were closing th [Read More...]

Services will boom according to the Reserve Bank of Australia. Sales assistants and tour guides are [Read More...]

In the many years since the creation of the US Federal Reserve System as America's central bank [Read More...]

In business, as in other things, we are being roughened up… and toughened up. We promised a grim acc [Read More...]

The worry is that the Russian and Ukrainian economies are suffering badly while politicians enjoy th [Read More...]

During good times, convertible notes behave like debt financing. But if there’s a bank crisis, the b [Read More...]

TESTIMONIALS

"I think you're fantastic! I love to read what you write...you're so interesting and amusing and I've learned so much" -
Money Morning reader, Chris Gadd

"You guys are brilliant. I feel more relaxed about the future than ever simply because I know what is going on rather than floundering around with smoke screens and mirrors from the government and mainstream" -
Money Morning reader, Helen Carter

"Wow what can I say? I was an economically confused moron until I read your newsletter and even though I've been a subscriber for a short period I can now see how easy it is to understand, if you use common sense and can have the spin translated into everyday language. Thanks for an entertaining read." -
Money Morning reader, John

"Keep up the good independent and well thought out articles offering a view that often debunks mainstream myths." -
Money Morning reader, Craig

"I do admire your straight talking and simple analysis of the situation, I think of you as the Jeremy Clarkson of finance." -
Money Morning reader, Jeffery