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Financial Meltdown in Cyprus: Could it Happen Here?

Michael Schreiber

Though we may be getting desensitized to European bailouts and the prospect of more of them, the recently proposed — and currently rejected — bailout in Cyprus is perhaps more likely to give us pause. The proposed European Union bailout of as much as $13 billion was offered with certain strings attached: namely that Cypriot bank deposits would be hit with a tax of either 6.75% or 9.9% depending on the amount of money in the account. The proposal was not received particularly well by the citizens of Cyprus.

“Politicians and senior bank bosses have covered each other’s backs for years, now it’s ordinary people who are paying the price and are being punished,” Christos Demetriades, 58, told the Associated Press outside a shuttered bank in Nicosia, Cyprus.

As word spread through Cyprus about the proposed bailout, citizens began lining up at banks to withdraw their money, and many banks closed. Though they’ve rejected the latest version of the bailout, the Cypriot Parliament will debate the proposal with the particular aim of protecting smaller depositors from having to pay the tax. Meanwhile, a scheduled bank holiday was extended from Monday through Wednesday.

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Could This Happen to Us?

All of this has nevertheless led to speculation about whether a similar situation could befall Americans. If American banks were in trouble, could they impose a tax on depositors? More importantly, if everyone rushed to take their money out of the bank in order to avoid the tax, would banks and ATMs shut down, as many have in Cyprus?

According to the Federal Depository Insurance Corporation, your money is safe and you shouldn’t worry.

“The FDIC’s core mission is to create stability in the banking system and to protect depositors’ savings,” said FDIC spokesperson David Barr. “During the current economic crisis, consumers have seen firsthand how the FDIC protects their money by swiftly making deposits available when a bank is closed. In the FDIC’s 80-year history, not a single depositor has ever lost a penny of insured money as a result of a bank failure. Our proven track record has helped prevent bank runs during some very difficult economic times.”

Indeed, the FDIC was created in response to the Great Depression in large part to prevent the kind of thing we’re seeing in Cyprus. The FDIC insures the deposits of up to $250,000 (up from $100,000 since the passage of Dodd-Frank).

What, however, would happen if the FDIC were to run out of money? There’s a mechanism for that too. Kathleen Day, a professor at the Johns Hopkins Carey School of Business who teaches a class in financial crises, says that in the event that the FDIC weren’t able to meet its obligations, the Federal Reserve would step in and provide the funds.

“At a time of crisis…the Federal Reserve Bank is the lender of last resort,” she explains. “The irony is that by ensuring that people can get their money, people don’t line up to get their money. It’s only when there is a problem that they line up. But the U.S. government is never going to let that happen.”

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Is That an Airtight Guarantee?

There are some considerations for depositors worried about the safety of their money, however. Let’s assume a bank fails and it’s either not covered by the FDIC or certain accounts contain more than the $250,000 limit. Could these depositors lose the uninsured money? Beyond that, let’s also consider what could happen if lots of banks needed to be bailed out. Could the government step in and tax deposits on everyone to pay for a portion that bailout, as has been proposed in Cyprus?

“There is no legal right to tax deposits in this country, and it would take a law change. I suspect that would be true in almost every country, and was apparently the case in Cyprus,” explains Ed Yingling, partner at Covington and Burling, and former CEO of the American Bankers Association.

Yingling explains that in the United States, the FDIC sells banks that have failed and when that happens, “Uninsured depositors can take a loss, the size of which depends on the value the FDIC gets for the assets of the bank. In reality, this seldom happens… However there are isolated cases, some recently, where depositors over the insurance limit have taken a loss.”

Pay Now… or Pay More Later?

For some, however, the idea that depositors might have to take a “haircut” as some call it, is not necessarily a bad thing.

“It’s completely incentive compatible,” says Joseph R. Mason, Professor of Banking at Louisiana State University, and a fellow at The Wharton School of Business. “This was the way banks would resolve themselves in the great depression. They would close down, make the depositors take a haircut, and then open a new bank which would buy the assets of the old bank at market value, and the depositors would often deposit their money into the new bank.”

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Mason also explains that banks have three types of asset-holders: bank stockholders, bank bondholders, and finally bank depositors. When a bank fails, the assets are liquidated and sold off in that order, meaning that the depositors should be the last to have to take a haircut. In the case of Cyprus, Mason believes that the haircut is likely the best option. Barring the bailout, many banks could fail and their assets could be liquidated. That process could take years.

“So what do you prefer,” Mason asks. “Ninety cents on the dollar now, or 60 cents on the dollar years from now?”

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