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What if We're Wrong About Cyprus and Jeroen Dijsselbloem?

What if We're Wrong About Cyprus and Jeroen Dijsselbloem?

Christopher Vecchio, CFA, Senior Strategist

Let me preface this by first saying that by no means would I consider myself a Euro apologist. I think the Euro crisis has been poorly handled from the start, and that the latest period of calm is nothing short of a farce, only thanks to the European Central Bank’s efforts to do “whatever it takes” to save the Euro, back in July 2012. But an end might be in sight for the Euro-zone sovereign debt crisis – and it’s not an exit that anyone has been looking towards.

The past few days have been mired by endless speculation over the precedent the bailout of Cyprus might set for other peripheral countries. After all, the Euro project is about equality and unity; and given the progression of the crisis, we know that each step has set the precedence for the next step. That is to say, the Cypriot bailout – one which looped in depositors to take the fall for banks’ poor investing (gambling) decisions – is now considered a “template” for the rest of Europe. By now, everyone has recycled the fact first brought to light by The Economist in this week’s issue: of the 147 financial crises since 1970, none of them resulted in depositors taking losses before Cyprus, according to the IMF. This is a unique case indeed.

But is it really a unique case? Eurogroup President Jeroen Dijsselbloem seems to disagree. In a revealing joint-interview with the Financial Times/Reuters yesterday, Mr. Dijsselbloem said that:

We should start pushing back the risks. If there is a risk in a bank, our first question should be: “Ok, what are you the bank going to do about that? What can you do to recapitalise yourself?” If the bank can’t do it, then we’ll talk to the shareholders and the bondholders. We’ll ask them to contribute in recapitalising the bank. And if necessary the uninsured deposit holders: “What can you do in order to save your own banks?”

So then Cyprus is not a unique case, it is the “blueprint” (another one of Mr. Dijsselbloem’s carefully chosen words) for future bailouts. The Euro has been hit quite hard as a result of this comment, falling from just under $1.3000 against the US Dollar into the mid-$1.2800s in a few hours on March 25. Everyone, including myself, was focusing on the latter half of the quote: those uninsured deposit holders would join their constituents as candidates to recapitalize a downtrodden bank.

I posited this morning that “The big question now: if you have over €100,000 in a country whose banking system is on life support, do you feel that your money is safe?” This was a direct reference to Italy and Spain, the two countries closest to the core affected by the debt crisis. Mainly, I would be terrified if my savings were past the €100,000 threshold – news broke today that a Swedish EU member of parliament was setting forth legislation that would put uninsured deposit holders (over the said €100,000 threshold) on the chopping block ahead of tax payers for bailout proceedings. This is a big deal in the short-term, but maybe not in the long-term.

On second glance, the main point that everyone should be taking away from Mr. Dijsselbloem’s comments is the first part of the sentence, when he said “We should start pushing back the risks.” We need to go to the root of the crisis to understand where the risks are stemming from: the strong interrelationship between banks and their sovereigns. Banks buy sovereign debt, sovereigns invest in the banks – it’s an endless loop where each party has their hand in the other’s pocket as well.

To truly end the European sovereign debt crisis, this strong interrelationship needs to be severed. A potential tax on uninsured deposit holdings is just the way to end it.

Before Cyprus, when a bank needed bailouts, they would go to their sovereign for funds. The sovereign would recapitalize the bank, and in return, the sovereign would get an investment in the bank. With the European economy in the gutter, quite frankly, many banks’ losses keep piling up, putting further strain on the sovereigns, while the banks don’t see a true penalty; moral hazard. The public debt racks up, government revenues can’t keep up the pace to pay off their own debt, and voila: the sovereign needs a bailout as well.

We’ve all been led to believe that the European Stability Mechanism (ESM) would be the facility by which these sovereigns would receive emergency funding. But the ESM is derived from tax payer money, which in effect would mean that the connection between sovereigns and banks remains. Mr. Dijsselbloem said that “We should aim at a situation where we will never need to even consider direct recap.”Now, like in Cyprus, it’s clear that tax payers won’t contribute to bailouts going forward.

Essentially, Mr. Dijsselbloem has placed deposit holders in front of the tax payers for bailouts. Risk is now diverted away from the sovereign – the severing begins. But why is levying a deposit tax, if you will, the right move?

In short, depositors are the life blood of a bank. Without depositors, the bank collapses. If a bank in a peripheral country is taking on extra risk to generate windfall profits – a quick and haphazard way of trying to cover holes in the balance sheet – it will be forced to curb its risk taking in order to shore up Tier 1 capital ratios, thereby preventing panic among its depositors. In the instance of a crisis on the sovereign level, banks with higher capital ratios could withstand the impact of sovereign debt writedowns, and the ‘Greek sovereign-Cyprus financial’ loop won’t happen again in the Euro-zone.

Of course, to get to the end of the crisis now looks like a messy road – selling of assets to raise capital, which would likely put upward pressure on peripheral bond yields. The pace of raising capital could be quick, now that Mr. Dijsselbloem has seemingly fumbled his words, with many calling him ‘inept’ in his wake. Luckily, the ECB has its OMT safety net in place – the facility that has quite literally saved Italy and Spain – and with its key rate at 0.75%, it could easily slash 50-bps to cushion the economy amid balance sheet contractions.

There may be some words lost in translation, but Mr. Dijsselbloem is no idiot – he’s the President of the Eurogroup. I still believe that this crisis is going to get a lot worse – but I’m also considering the notion that Mr. Dijsselbloem may have unlocked the door to truly pushing back the risks, by changing the pace and direction of the Euro-zone crisis. Now that banks have skin in the game, the game is about to change.

--- Written by Christopher Vecchio, Currency Analyst

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