Cyprus fails, depositors taxed to support the country

Over the weekend the IMF, the EU and the ECB agreed to bail out Cyprus. The €10bn rescue involves a bail-in on junior bondholders, meaning senior bondholders are protected but anything lower will face a full loss. Worryingly, for the first time in Europe, the rescue is conditional upon depositors contributing to the bail-in. Deposits below €100,000 will be taxed 6.75% and those above 9.9%, for a total contribution of €5.8bn. In exchange, depositors will receive bank equity as compensation, although this is likely to be worth very little, if anything for many years.

Past failures have always seen protection of depositors. The precedent could see depositors in peripheral countries like Portugal, Spain and Italy withdraw funds from bank accounts. Could it mean a run on deposits in Europe? Possibly but I think most of the damage will be contained given special circumstances. Cypriot banks are very large with assets of €125bn, seven times the size of domestic economy. They also have very few bonds outstanding, around €2bn in senior and subordinated debt, making a bond holder bail-in, ineffective.

I think the actions of the regulators show a preference for keeping the overall system intact and allowing investors in smaller more vulnerable institutions and countries take the pain.

Likely consequences are that depositors will withdraw funds from smaller European banks and institutions and deposit them with larger and thus perceived as safer institutions. It could lead to a run on some of the smaller banks with a possible increase in defaults.

The bail-in of subordinated bondholders highlights the need for investors to be paid more for the risk they are taking, the lower they sit in the capital structure and the ultimate protection of senior bondholders. The actions by regulators here are a reminder that Europe still faces many hurdles and we’d expect jittery markets in the weeks to come.

Note that Australian subsidiaries of the two Cypriot banks that operated in our local market were both sold in 2011, hence   removing any possible link between Cyrus and Australian Authorised Deposit-taking Institutions (ADIs). Laiki Bank Australia was sold to Bank of Beirut for $420m and renamed Beirut Hellenic Bank. Bank of Cyprus Australia was acquired by Bendigo and Adelaide Bank in December 2011 for $130m and is now called Delphi Bank.  Deposits in both of these banks have no connection with Cyprus and are not subject to the levies or taxes being imposed.