Europe: No Need To Worry, The Fire’s Downstairs

“Am I jumping the gun, Baldrick, or are the words 'I have a cunning plan' marching with ill-deserved confidence in the direction of this conversation?” Edmund Blackadder

Jeroen Dijsselbloem has been pilloried for his remarks following the conclusion of a deal with Cyprus. But is the assault just self-interested finance apologists (like, presumably, me) appalled at having their snouts removed from the public trough? Or are digs about his qualifications proving justified?

First up – let’s be clear. The EU is pretty emphatic about what the future of bailouts looks like: No more blank cheques, the ESM will not become a TARP, and uninsured depositors are in the firing line, as are senior bondholders; taxpayers are not. In this, both Mr Dijsselbloem and the rest of the European authorities are in agreement.

If the bank can’t do it, then we’ll talk to the shareholders and the bondholders. We’ll ask them to contribute in recapitalising the bank. And if necessary the uninsured deposit holders: “What can you do in order to save your own banks?” In other words, taking away the risk from the financial sector and taking it onto the public shoulders is not the right approach. If we want to have a healthy, sound financial sector, the only way is to say: “Look, there where you take on the risks, you must deal with them. And if you can’t deal with them, you shouldn’t have taken them on and the consequence may be that it’s end of story.”

Aside from the incitement to panic added to the end, there’s nothing new in the substance – the EU is clearly moving to bail-ins, as it should with a banking sector this vast. The EU Working Paper linked above is from June last year:

by removing the implicit certainty of a publicly-funded bailout for institutions, the option of resolution should encourage uninsured creditors to better assess the risk associated with their investments.

We’ve had a steady stream of denials that Cyprus is a template (a word which, incidentally, I can’t see either the FT using at all, or Reuters implying he used). We’ve had roughly nothing to contradict the principle that uninsured depositors are in the firing line. Pro tip: when someone says “insured depositors will be protected” they mean “uninsured depositors will not”. And there’s nothing new here – David Keohane has more detail, along with the far-from-trivial detail that this masterplan is part of a new regime that’s due to come in 2018.

So far, so fine and dandy. There’s plenty to like about this in principle – it’s consistent, it’s transparent, it doesn’t put taxpayers on the hook for open-ended sums, and it’s progressive – things that hurt only people with more than €100,000 tend to be. In this case, the Eurogroup is being assaulted for doing no more than telling the truth.

However, there are two important problems here 1) depositors over €100,000 control enough money to overturn the European economy if they stampede; 2) there’s – to a fairly fine level of precision – zero evidence that the people in charge know what they’re doing. In short, the last thing the Eurozone needs right now is uninsured depositors thinking hard about the prudence of their investments.

Here’s two really interesting* tables

(It’s from Annex 3 & 2 here – 2007 data, but hard to imagine there’s been a fundamental change in the data, Ireland and Greece aside).

So while the vast majority of individual depositors are covered, a very, very substantial chunk of the European money supply isn’t. Capital movements accounting for a small fraction of this amount are a major cause of the severity of the peripheral slowdown. You cannot dick around with money on this scale unless you know what you’re doing. To suggest that the bail-in legislation is a problem for the periphery and uninsured depositors is to say that the fire is downstairs.

The FDIC is the chosen comparison for the optimists. But the FDIC works best with small banks (of which Europe has comparatively few); when Wachovia, Citi and Bank Of America ran into trouble, the FDIC was not left to do its job. And the US banking sector assets are around 80% of GDP, vs around 3x that for the Eurozone.

To raise the issue of depositor bailins now – five years ahead of schedule and with nothing in the way of a resolution regime would show impressive hubris had the Cyprus operation gone well. It didn’t. It was a complete disaster. If I had been in charge of European policy for the last week, I’d like to think I’d be suicidally depressed. I would be stuck in bed with a bottle of vodka, refusing to emerge unless finally coaxed out by someone willing to lie that the Cypriots would be willing to forgive me.

From undermining the EUR100,000 deposit guarantee, to wiping out and freezing business working capital, to hammering businesses ahead of the April VAT payment, the execution alone is crammed with unforced errors. A politically stupid plan, rejected by an equally culpable Cypriot parliament, was replaced with a worse one has inflicted massive, irretrievable destruction on the economy of Cyprus. There’s a great deal to be said for commercial experience and gradual rollout. If Coca-Cola had tested a new product that killed 10% of the focus group, it’s reasonable to assume that they’d hesitate with the global rollout of Cyprus Cola. Instead, Mr Dijsselbloem is clapping the dust off his hands, announcing that he thinks this all went rather well, and looking to have another crack somewhere else. And it appears he’s decided to start with further scaring already skittish large depositors.

source: Nomura

The European banking system cannot be remade piecemeal. We either hold things together until the resolution regime is in place or introduce a Roosevelt-style emergency Banks Act and remake the system. A major shift in uninsured deposits risks precipitating a crisis that hurts everyone – insured or not, periphery or core – or even outside the euro. Given that Europe’s banking experts looked at both Laiki and Bank of Cyprus and found they were good, yet we’re now hearing the Cypriot finance minister talk of 80% haircuts on Laiki, a little more humility – and even an admission that things went badly – would be far more reassuring than the current confidence.

In short, I’m howling because we have rank amateurs playing a high-stakes game without understanding either the rules or what’s at stake. Maybe our masters have plans for a controlled detonation of a massively complex and unstable system. But I see damn all evidence of that. Instead we appear to have a group of underqualified provincial politicians who, having been badly mauled by a housecat are looking to pick a fight with an alligator. (/rant)

Many thanks to: @goodrichwatts, @katie_martin_fx, @lorcanRK, @toby_n and@harveyrobinson1 for their help with this post. and the Cyprus presentation is by @alexapostolides.