Will Irish savers be next to pay as EU targets Cypriot depositors?

At the heart of modern finance is the concept of the risk-free rate.

That is the rate of return on an asset whose repayment is certain.

For many years we have sought this and now we know.

The truly risk-free asset is a senior bank bond in a peripheral bank in a country seeking a bailout.

We know that from the Irish case senior bonds took equality with the deposits in Anglo (except at the very end) and were certainly much more important in the eyes of both governments than mere taxpayers.

We now see in Cyprus that these assets are truly special and rank above even deposits.

Having sustained deep financial wounds from the first Greek bailout, Cyprus needed €17bn. Its banks were financed mainly by deposits but there were some bonds there... so the logical thing was to first burn these.

Instead, and setting a dangerous precedent, the ECB and the Economic and Financial Affairs Council (chaired by Michael Noonan, fresh from lading €25bn of Anglo debt onto the Irish taxpayer) decided to haircut depositors.

All depositors over €100k were to lose 10%, those under, who had been guaranteed, are to lose 6.75%.

Why did Cyprus need a bailout? For one main reason, its banks. They got too large too fast. There is a massive link between the Greek and Cypriot economies, as the Greek situation went from bad to catastrophic, the Cypriot banks were holed badly, having extended credit equivalent to over 150% of Cypriot GDP to Greece.

These private sector loans are now damaged and the Cypriot banks were further weakened by the writedown of Greek official sector debt.

Cyprus is criticised for having an overly large banking sector and, at seven times its GDP, it is too large. Part of the reason it is too large is that Cyprus, like another small island we can think of, operates as an offshore financial centre. And here we see a rancid whiff of racism and xenophobia.

The meme is “Cyprus is stuffed with hot money from Russia,” and so any hit to the banking sector will show Ivan who’s boss — Angela, in case anyone wondered. That this is improbable, and that the data suggest that perhaps €7bn of the total €70bn deposit base of the Cypriot banks is held by Russians from Russia, some of which may be hot, is irrelevant. Anyhow €7bn would hardly get you into oligarch circles nowadays. But the meme persists.

Cypriot banks were seen as safe, and so were attracting large flows from Greek and other depositors. The largest growth in non-EU money came from other financial institutions, not households or corporations. And so, faced with 90% debt GDP ratios and fast out of money fast, the Cypriots have been asking for a bailout since last June. Despite this, it took another 3am meeting, chaired lest we forget by Michael Noonan, to decide on an extraordinary course of action.

A bailout of €17bn would have caused a massive spike in the debt/gdp ratio, and there seems still, five years after Bear Sterns, to be no willingness in the chancelleries of Europe to realise that a union means solidarity. Faced with the requirement to restructure Cypriot sovereign debt to make the total sustainable, Cyprus’ European partners, ourselves included, forced them to raid the savings of the Cypriot people. Although the Cypriot banks have little senior debt this was, and here we are into Alice in Wonderland territory, not burned.

And this was accompanied by the by now familiar hectoring and bullying, with the threats of the ATMs running out and the ECB cutting off liquidity and who knows what. All reports suggest, frankly, a hegemonic Germany run amok and declaring fiscal war on another small state. That should make everyone worried. This is dangerous territory, setting a bad precedent. Its unjust and incoherent.

European banks are funded by approx €5tn bonds, €21tn deposits and €3tn capital. They need to increase the reliance on deposits, and this makes them deeply unattractive outside the core. Plus, for all the fine talk on breaking the bank-sovereign link, this reinforces it. If this doesn’t cause a bank run in Cyprus it will be astonishing.

Its unjust in that even the smallest saver in Cyprus is forced to participate. But in a Europe that is happy to see Greek cancer patients suffer on the altar of ordoliberalism, I guess the widow’s mite counts for little.

Most of all it is a bad precedent. It is one that should worry any depositor in any eurozone country that is or might be in a bailout. For the first time in modern European history we see the deposits of ordinary savers at risk. While deposits have been lost in extraordinary bank failures, this is new territory. It puts at risk every deposit of every saver in every country now in or facing into a bailout. While we laud ourselves for having re-entered the market, our bond yield is depressed by a flood of cheap money and an attractive carry trade. The fundamentals are still shaky and our banks still face large losses from mortgages and there is still a chance they will seek additional funds.

So, if a future Irish or Spanish or Italian government seeks some assistance from Europe the precedent has been set to seize deposits while saving bondholders. This is crackers, and is driven solely by domestic German political considerations. Angela Merkel may have destroyed the euro by making it clear that a Cypriot euro is 90% of a German one. We await developments to see how much of a German euro an Irish, or Spanish or Italian one is.

* Brian Lucey is professor of finance at Trinity College Dublin