DEUTSCHE BANK: Here's Why The ECB May Not Rescue Cyprus

Mario Draghi ECB governing council boardMeeting of the ECB governing council

Following the Cypriot parliament’s total rejection of the controversial bank bailout deal reached by EU finance ministers over the weekend, the ECB released a statement saying that it would provide liquidity to Cyprus “within the existing rules.”

Emergency Liquidity Assistance is the ECB’s last recourse for euro zone banks that find themselves unable to raise funding in the open market through bond issuance.

However, as several pointed out following the statement, Cypriot banks probably don’t even qualify for ELA, which means the ECB may have really been saying something more along the lines of “don’t count on it.”

Deutsche Bank economist Mark Wall explains in a note to clients.

“The provision of ELA funding is normally conditional on the receiving banks remaining intrinsically solvent,” says Wall. “With the prospect of a bank run starting immediately after the expiry of the bank holiday, this condition hardly holds.”

In fact, Wall writes that the ECB is probably even incentivized NOT to step in and provide assistance for the Cypriot banking system:

Still, on balance, the limited direct impact – plus a state of “non-emergency” in Cyprus itself due to the bank holiday and the availability of cash via ATMs – probably incentivizes the ECB to stand firm and effectively turn the tap off. Indeed, we think that yielding to Cyprus’ pressure would create a dangerous precedent for the central bank in the eyes of the Governing Council.

We do not think that the European governments could take the political risk of backtracking now on the deposit levy. This “strategy of tension” is obviously bad news for the Euro area in general, but a tough response by the central bank is probably – unfortunately – what it will take for the negotiations to resume.

Indeed, the perspective of seeing Cyprus shut from the European liquidity system is unlikely to do much good to the country’s standing as an appealing off-shore financial centre, beyond the very uncomfortable impact that such a move would have on the Cypriot economy (all these events taking place just a few weeks before the opening of the tourism season).

Wall thinks that the complete rejection (zero votes in favour) of the bailout deal in Cypriot parliament yesterday, despite a new provision exempting those with bank accounts containing under 20,000 euros from a levy on deposits, indicates that “the ‘reprofiling’ of the levy, which was obviously open to negotiations with the troika, was not the main issue.”

“More likely,” Wall writes, “it is the very principle of a bank levy – and the adverse consequences it would have on the country’s standing as an off-shore centre – which is being overwhelmingly rejected by Cyprus’ political circles.”

However, given the incentives of the ECB and EU politicians, Cyprus may not have much of an option. Wall thinks the only rational thing for Cyprus to do is accept a deal with the EU that includes a deposit levy, “even if some sweeteners have to be found (e.g. on the austerity measures).

“As each day goes by, however,” says Wall, “the cost of the stalemate for Cyprus increases.”

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