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Does the Cyprus ‘Bail-In’ Open the Door for Private Deposit Insurance?

By Terry Connelly

The free-world equity markets momentarily quivered when – in a moment of either candor or hubris or both, Dutch Finance Minister and incoming leader of the eurozone Finance Ministerial conference negotiating Cyprus’ survival in the euro – opined that the terms finally agreed should serve as a template for resolving future crises involving eurozone bank solvency.

In particular, the markets – not to mention a select group of Russian multi-millionaires with large deposits in the leading Cypriot banks – focused on the terms requiring uninsured depositors in those banks to “contribute” what has turned out to up to 60% of their bankbooks to the “bail-in” recapitalizing the surviving bank to at least notional solvency. If this were to be the new model for eurozone rescues of profligate banks wreaking financial havoc on profligate governments (see Ireland, Portugal, Spain, Greece, Italy) then deposits in those banks beyond the local deposit insurance levels recently set in place by the eurozone were now fair game in the same sense as the unsecured bondholders who were haircut in the Greek recue last year after being spared in previous bail-outs. For bondholders, the way out of tis predicament would be “sell” – IF there are any buyers at the first sign of meltdown. But for depositors, in the brave new world of a eurozone free of capital controls, the way out would be much easier: just “run” – as in, Run on the Bank.

The new man in charge of the Finance Ministers’ didn’t seem to be kidding around, even if he forgot about the potential of a “run on the bank” thing. (Cyprus, as part of its “deal” got an exception to the “no capital controls” code to keep the Russians from running off with more than 40% of their money. That means there are euros and there are Cyprus-euros, but that’s a subject for another blog.) Mr. Jeroen Dijsselbloem spelled it out: in the future, he told the Financial Times and Reuters in his first post-deal interview, if there is “a risk in a bank, the first question will be ‘Okay, what are going to do about that?’ If the bank can’t [recapitalize itself] then we’ll talk to the shareholders and the bondholders, we’ll ask them to contribute” to recapitalizing the bank, “and if necessary the unsecured depositors.”

Doubling on down on his impersonation of Mister Potter from “It’s a Wonderful Life” (apparently confusing him with the hero), the rookie of the year in the “let’s sink the euro” club league went on to drop the “caveat depositor” bomb – which one might well mistake as a starters gun in for the four-country Bank Run. “When you take on the risks, you must deal with them. And if you can’t…then you shouldn’t have taken them on.”

Put another way, Dijsselbloem was telling large-scale euro-depositors that they need to engage a team of lawyers and accountants equivalent to the drafting team for a public bond indenture before they walk up to the teller anywhere south of Germany, north of the Mediterranean and west of (pardon) Russia.

The Finance Minister of Portugal was the fist to express apoplexy (in eurospeak): he just said there was no such agreement on the template. And after a few hundred points of market downturns in Europe and the US, plus a minor rush into US Treasuries and a penny off the euro, even the rookie took another minute to think and had a spokesperson walk-back the “template” designation.

His ghosted, belated, Emily-Litella-from Saturday-Night-Live “Never mind” did keep the day’s market downturn brief. Even the US hedge funds, desperate to be bailed out of their market-short positions at the close of the best first quarter in over a dozen years, couldn’t turn a new uber-bureaucrat’s rookie mistake into a “chicken little” moment for the future of the euro and global equities.

The Cypriot banking situation is indeed clearly distinguishable, as everyone that is a member of the multiple committees dealing with the euro crisis now repeatedly reiterates (guess they remembered about bank runs). Cyprus is utterly dependent on large external bank deposits (which it unwisely lent onward to the Greeks to the dismay, one supposes of the rest of Cypriots who are Turks); their banks don’t have enough bondholders to recapitalize a branch. The Cyprus “bail-in” had nowhere else to turn.

But the Dutchman has left a very big hole in the dike of euro-stability nonetheless. Once you have used a tool successfully once, it becomes hard to keep it locked in the toolbox when another problem comes along even if it’s only somewhat similar, especially if you are running out of tools that work at all. The “if all you have is a hammer, everything looks like a nail” syndrome is part of political nature: especially when there is a German election coming up and the parties are competing as to which can be the most hard-nosed in making the Southern Tier profligates use their own resources, not those of German taxpayer, to recap their banks and governments.

Bank runs would of course be a logical outcome of any extended public deliberations of a general policy taxing or seizing uninsured deposits to keep countries in the euro if all else fails or even just as a “contributory” private sector involvement in future bail-outs or bail-ins. “Temporary” capital controls would have to accompany any such move to inhibit runs – the French even have a phrase for that. And capital controls broadly imposed would doom the euro: a “common currency” that can’t move within common borders is one in name only.

But given the German attitude and the Dutchman’s new powers, what are depositors to do to protect themselves? Despite what the Dutchman said, most of them, except for sophisticated financial corporations, really don’t have the ability to conduct their own “stress tests” on every bank they might favor with their friendly cash. They could demand more interest for their risk of confiscation, but that would hardly be enough to cover losses like the Cypriot depositors are suffering. But their dilemma does open the door to creation of a whole new branch of the insurance industry – private deposit insurance.

Big league insurance companies could perform the stress tests needed to certify that a particular bank represent an acceptably low degree (or not) of “bail-in confiscation risk.” They can hire and direct bank examiner types (at higher than government pay) to in effect provide a form of rating analogous to those used by public bondholders; even better in terms of objectivity, they could be paid by fees from large depositors, not the banks. For big depositors, the fees would be offset by demanding higher interest from the banks – a match with economic symmetry.

If such a “free-market” deposit insurance scheme were to take hold, the Dutch Finance Minister might even live to see his now infamous interview inscribed on the walls of some future Germanic Hayek Hall. It would not be the first mistake in European policy that turned out to be a prediction of things to come. And governments and even central bankers might be able to get out of the “stress-test” business (nobody really trusts theirs, anyway). The Dutchman’s Bazooka “template” might never even have to be fired. And rich Russians might someday bank with the Vatican, which still keeps its faith in the euro.

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.