Citi chief economist Willem Buiter has been one of the sceptics towards official policy over the course of the Eurozone crisis.Ever since ECB President Mario Draghi put markets to bed for an extended rest in July with his “whatever it takes to save the euro” speech, Buiter has been pointing out the shortcomings that still remain in the euro area, explaining why it’s not really been fixed.
Interestingly, though, the Cyprus bailout deal that has seemingly out of nowhere created a political firestorm in Europe this weekend is actually “qualified good news,” according to Buiter.
In a note today titled “The euro area recovery starts with Cyprus,” Buiter explains why.
Despite all of the criticism of European politicians’ choice to force depositors to take a haircut as part of the bank bailout – an unprecedented move in the euro area, where deposits were formerly viewed as sacrosanct – Buiter thinks this is a good sign.
While the idea of the government seizing part of your bank account without asking to bail out poorly-regulated banks is rather appalling, that’s really missing the bigger point.
Buiter clarifies that he would have preferred the “tax” on deposits to be more progressive – shouldered less by those with smaller bank accounts and more by those with bigger ones.
“We think it would have been desirable: i) for insured depositors (below €100k) to be spared, ii) for haircuts on larger deposits to be made bigger to satisfy the entire recapitalization need of the banks, and iii) for losses to reflect recapitalization needs of each bank,” he writes.
And the Cyprus bailout deal may be tweaked to align more closely with those wishes by the end of the week anyway, as it makes its way through a parliamentary vote.
However, the bigger point here is that European officials are finally moving toward more private-sector involvement in these bank bailouts. That means, instead of fighting more debt with debt, Europe is finally getting serious about restructuring.
In other words, taxpayers are being asked to foot less and less of the bill with each bailout, and this is a good thing, because there’s really no way the euro member states with struggling banking systems can continue to bail them out on the back of the taxpayers. There’s just too much debt on governments’ balance sheets already, and it keeps piling up.
“In particular, this episode highlights that creditors are likely to make a major contribution to the deleveraging of excessively indebted banks and sovereigns (as well as non-financial businesses and households in some cases) in the euro area,” says Buiter.
While a lot of the worries surrounding the Cyprus deal focus on the involvement of depositors, there really is a good reason to believe that Cyprus is unique in that regard. Namely, the Cypriot banking system is largely funded by deposits – owing mostly to its reputation as an offshore tax-haven for moneyed Russian interests – as opposed to bank debt. So, in this case, there really wasn’t going to be any money raised from forcing bank creditors to take a haircut. (A haircut on what?)
The decision to include depositors in the Cyprus deal sends the message, regardless of what European politicians say, that the involvement of creditors in other banking systems, like Spain, which are funded more by debt than deposits, is on the table now.
In his note, Buiter writes:
The Cypriot bank creditor bail-in is a net positive for the euro area, first, because it paves the way for more extensive debt restructuring of excessively indebted banks as well as other private sector entities and sovereigns. Such accelerated debt restructuring is necessary for the euro area to return to sustainable growth soon – without risking a lost decade to follow the lost half decade since 2008.
Second, the Cyprus depositors bail-in is also good news politically, as it will limit additional bail-out fatigue in EA creditor countries and avoids putting the burden of bailing out investors to an even more unbearable extent on taxpayers and beneficiaries of public spending in debtor countries.
Third, the bank creditor bail-in improves the creditworthiness of the Cypriot sovereign compared to the alternative where an additional €5.8bn worth of bank recapitalisation demands were to land on the public sector balance sheet. Other sovereigns in Europe will find their creditworthiness improved (at the same time that banks’ creditworthiness is further impaired) if markets perceive a greater likelihood of unsecured bank creditor bail-ins rather than taxpayer rescues of unsecured bank creditors.
That’s not to say that there won’t be a market correction. After all, Europe has staged a considerable rally, and it may be pretty stretched at this point.
Buiter acknowledges that there could be contagion in other peripheral euro zone countries from depositors who now think their savings accounts may be at risk, but he says it’s way overstated at this point (referring to it in his note as “the contagion myth”).
Nonetheless, if it happens, it can be dealt with, writes Buiter:
The right policy response to any threat of contagion is clear. If contagion is fundamentally warranted, that is, if the banks affected by a deposit run would be at high risk of insolvency even if they were able to fund themselves on terms that did not reflect a material risk of insolvency, the optimal policy response is to restructure the banks in question as soon as possible. This would require wiping out the existing equity and recapitalizing the banks through the bailing in of unsecured creditors, starting with the most junior ones and progressing up the seniority scale up to the point that the banks are adequately capitalised.
If contagion is not fundamentally warranted, but instead merely represents the self-fulfilling ‘bad equilibrium’ outcome, in which high default risk premia trigger default even though there also exists a good equilibrium outcome where low default risk premia support the absence of any material default risk, then again the right policy response is obvious: let the ECB/Eurosystem act as lender of last resort to the banks in question, supporting them until those expecting their demise, or their risk officers, run out of patience and ammunition. The ECB has the resources to play this role, as no-one can defeat a determined ECB when euro-denominated funding capacity is the issue.
The bottom line still stands, though: this is ostensibly the right direction for cleaning up the mess that is the euro zone banking system.
“Recognising that a view of the world and a strategy based on it have become untenable is the beginning of wisdom,” says Buiter. “The euro area political leadership is at last ready to put senior unsecured bank debt on the table, as a candidate for debt restructuring. This is an important step, long overdue, in the direction of a comprehensive deleveraging through debt restructuring of banks, sovereigns and, in some countries, households.”
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