Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.
Firstly, depositors were presumed to be guaranteed by governments up to at least €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.
My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?
Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.
Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?
The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.
So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.
No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.
I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.
Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.